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Adviser’s Dual Employee Caused Violations of Custody Rule

The SEC censured and fined an investment adviser and its principal for violating the custody rule because a dual employee also had trust powers.  The adviser and a trust company engaged in a joint offering whereby each recommended the other’s services and shared office space.  The trust company paid the adviser monthly “rent” based on the trust company’s revenue from the adviser’s clients.  The adviser also appointed a dual employee that could receive and deposit checks as well as write checks on trust accounts to beneficiaries.  The SEC asserts that the adviser violated the custody rule (206(4)-2) because the adviser, through the dual employee, had constructive custody of client assets, but the adviser failed to satisfy the rule’s requirements including notifying clients, segregating client assets, and engaging a surprise examination conducted by an independent public accountant.

OUR TAKE: Last year, the SEC cited violations of the custody rule as common exam deficiencies.  While we think the rule is arcane and complicated (and needs re-drafting), advisers should seek expert help to understand when they are deemed to have custody and how to address the rule’s requirements.  As shown in this case, the SEC can bring an enforcement action even without alleging any underlying client complaint or loss.


Adviser Failed to Stop Principals from Looting Client Accounts

The SEC censured an investment adviser and ordered it to pay $1.7 Million in fines, disgorgement, and interest for failing to implement a compliance program that would detect and prevent the looting of client accounts.  Two firm principals ultimate went to prison for using their positions as fiduciaries over trust accounts to steal funds.  The SEC faults the firm for (i) failing to adopt legitimate policies and procedures, (ii) neglecting to obtain the required surprise examinations, and (iii) preparing misleading Form ADVs.  In addition to charging violations of the Advisers Act fiduciary, custody and compliance rules, the SEC also cites violations of Section 10(b) and Rule 10b-5, which prohibit fraudulent conduct in the offer or sale of securities, presumably for misleading statements made in Form ADV.

OUR TAKE: Just because the principal wrongdoers went to jail doesn’t mean the firm is off the hook.  The SEC holds the adviser accountable for allowing the conduct to continue.  It is also significant that the SEC uses 10b-5 as a charge, which opens the door to more significant civil and criminal penalties.


Adviser Looted Trust Accounts and Over-Charged Clients

 The SEC barred an investment adviser from the industry and ordered him to pay over $1.7 Million in disgorgement in part for looting trust accounts for which he served as a trustee.  According to the SEC, the adviser sold trust assets and purported to replace those assets with lesser-valued securities in which he had a personal interest.  The SEC also accuses the adviser of over-charging management fees and making misrepresentations about conflicts of interest.

OUR TAKE: This type of misconduct is exactly why the SEC should move forward and require all advisers to obtain third party compliance reviews in an effort to weed out wrongdoers.  The custody rule (206(4)-2) deems an adviser to have custody where the adviser serves as the trustee of a trust, and requires an annual surprise examination to verify assets and prevent looting of the trust.  Unfortunately, an adviser that is willing to steal from clients probably doesn’t prioritize compliance.


Standing Letters of Authorization Cause Advisers to Have Custody

The staff of the SEC’s Division of Investment Management, in a recent No-Action Letter, has opined that an adviser has regulatory custody of client assets where a client grants even limited authority to transfer assets to a designated third party.  As a result, an adviser who has received standing letters of authorization (SLOAs) from one or more clients must report those assets in its response to Item 9 of Form ADV.  The staff will allow such an adviser to dispense with the custody rule’s surprise examination requirement so long as it meets several conditions including ensuring that the third party custodian appropriately verifies the SLOA, provides transfer of funds notices to the client, and sends the client annual reconfirming notices.  In companion releases, the staff also provided guidance about transferring assets between custodians and inadvertent custody arising from custodial contracts.

OUR TAKE: The IM staff continues to take a hard line with respect to its broad view of the custody rule regardless of the underlying policy arguments.  The relief from the surprise audit may be cold comfort, as we expect few custodians will be willing to spend the resources and subject themselves to additional liability to accommodate SLOAs (without additional fees).


Large Adviser Fined $13 Million for Predecessors’ Compliance Breakdowns


A large investment adviser agreed to reimburse clients and pay a $13 Million penalty for compliance breakdowns related to fee billing, custody, and books and records.  According to the SEC, over a 15-year-period, the respondent overbilled clients because of coding and administrative errors included in predecessor firms’ billing systems.  The SEC faults the firm for failing to test and uncover the over-billing when it integrated the systems.  The SEC also accuses the respondent of violating the custody rule’s surprise audit requirement by failing to properly identify the accounts subject to audit.   Also, the SEC faults the firm’s books and records practices for failing to retain client agreements.  The SEC cites violations of the Advisers Act’s custody rule (206(4)-2), compliance rule (206(4)-7), and books and records rule (204-2).

OUR TAKE: Integrating operations following a combination should trigger compliance due diligence into the prior firm’s policies and procedures. Also, firms should include compliance due diligence as part of the acquisition process.