# Custody Rule — Safeguarding Client Assets

## What It Is

The Custody Rule (Rule 206(4)-2 under the Investment Advisers Act of 1940) requires registered investment advisers who have custody of client funds or securities to follow specific safeguards. The SEC updated these requirements significantly with the new Safeguarding Rule (adopted 2023, compliance dates phased in through 2026).

"Custody" means holding, directly or indirectly, client funds or securities, or having the authority to obtain possession of them.

## When a Fund Manager Has Custody

A fund manager is deemed to have custody when:

- The fund's assets are held in accounts the manager can access
- The manager has authority to withdraw funds or securities from client accounts
- The manager serves as general partner or managing member of a pooled investment vehicle (this is the most common trigger for private funds)

**Palace Fund**: As the managing member of a California LLC fund, the manager automatically has custody of fund assets.

## Requirements for Registered Investment Advisers

If the manager is a registered investment adviser (SEC or state), the Custody Rule requires:

1. **Qualified custodian**: Fund assets must be held at a qualified custodian (broker-dealer, bank, or futures commission merchant)
2. **Account statements**: The qualified custodian must send account statements directly to investors at least quarterly
3. **Annual surprise examination**: An independent public accountant must conduct a surprise examination of fund assets annually, OR
4. **Annual audit exception**: The fund can avoid the surprise examination if it distributes audited financial statements (prepared under GAAP, audited by a PCAOB-registered accountant) to all investors within 120 days of fiscal year-end

## Exempt Reporting Advisers

If Palace Fund's manager operates as an exempt reporting adviser (ERA) under the Advisers Act:

- The Custody Rule technically applies only to registered advisers
- However, the SEC's antifraud provisions still apply to ERAs
- Best practice is to follow custody safeguards regardless of registration status
- State regulators may impose their own custody requirements

## How It Applies to Palace Fund

### Practical Steps

- **Use a qualified custodian**: Open brokerage accounts at a recognized broker-dealer (Interactive Brokers, Schwab, Fidelity). The account should be in the fund's name (Palace Fund LLC).
- **Choose the audit path**: For a small fund, the annual audit exception is simpler than arranging surprise examinations. Engage a PCAOB-registered accounting firm to audit the fund's financial statements annually.
- **Investor statements**: Even if not strictly required as an ERA, send quarterly account statements or make them available through a portal. The qualified custodian will also send statements directly.

### Korean Investor Considerations

- Korean investors may expect formal documentation of asset safeguards
- Providing evidence of a qualified custodian and annual audit supports regulatory compliance for Korean investors reporting to Korean authorities
- FIPA (Korean Foreign Investment Promotion Act) and Korean financial regulators may require proof that assets are properly custodied

## Costs

- **Annual audit**: $15,000 to $40,000 for a small fund, depending on complexity
- **Qualified custodian fees**: Included in normal brokerage fees for most broker-dealers
- **Surprise examination** (if used instead of audit): $5,000 to $15,000

## Action Items

1. **Open fund accounts at a qualified custodian**: Use a recognized broker-dealer. Ensure accounts are titled in the fund's name.
2. **Never commingle**: Fund assets and manager's personal assets must be in separate accounts.
3. **Engage an auditor**: Hire a PCAOB-registered accounting firm for annual audits. Start this relationship before the first fiscal year-end.
4. **Document custody arrangements**: Include custodian details in the PPM and operating agreement.
5. **Send regular statements**: Provide investors with quarterly performance and account information, supplemented by custodian statements.
6. **Review the new Safeguarding Rule**: Monitor SEC compliance deadlines for the updated rule (phased implementation through 2026).

## Key Takeaway

As managing member of the LLC fund, Palace Fund's manager has custody by definition. The simplest compliance path is to hold all assets at a qualified custodian (a mainstream broker-dealer) and have the fund audited annually by a PCAOB-registered accountant.