Custody Rule Enforcement

The Securities and Exchange Commission has been pointing out custody issues for investment advisers, made it an exam priority for 2014, highlighted in its presence exam initiative, and highlighted it in its never before examined initiative. So it should come as no surprise that the SEC brought an enforcement case solely for custody rule violations.

The SEC brought charges against Sands Brothers Asset Management LLC, its co-founders Steven Sands and Martin Sands and its chief compliance officer and chief operating officer Christopher Kelly. They are contesting the charges, and we don’t have they’re side of the story.

I think you should pay attention to what the SEC highlighted in the press release as the violations:

According to the SEC’s order instituting an administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010.  The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late.  The same materials for fiscal year 2012 were distributed to investors approximately three months late.

The SEC is pointing out very technical violations. Since it’s a 206 violation, the SEC does not have to allege intent to defraud or investor harm. Technical violations are enough.

Behind the scenes, the SEC is alleging more bad actions. According to the SEC’s order, Sands Brothers and the two co-founders were previously sanctioned by the SEC in 2010 for custody rule violations. One of the top things to do when getting a bad mark from the SEC is to fix the problem. The Sands knew there was a problem and apparently continued to violate the custody rule.

Private fund managers can comply with some aspects of the custody rule by distributing audited financial statements to fund investors within 120 days of the end of the fiscal year. That is generally an easy standard because most private funds are required to deliver audited financial statements to investors each year within that time frame. As much as a fund manager does not want to violate an SEC rule, a fund manager does not want to intentionally violate its explicit obligations under its partnership agreement.

The tougher part of the custody rule for fund managers is older, legacy funds and parallel funds that are not required to be audited and the investors do not want to pay for an audit.

Sources:

• SEC Announces Charges Against Investment Advisory Firm and Top Officials for Custody Rule Violations
• SEC Order against Sands Brothers
• SEC Investor Bulletin: Custody Rule
• SEC Brings Custody Rule Enforcement by Jay Gould in Pillsbury’s Investment fund Law Blog