The Custody Rule is full of foot-faults. The concept is easy: have a third party make sure that the investment adviser is not stealing money. That turns out to be a bit harder in execution.
Mohlman Asset Management Fund was using the accounting firm Katz, Sapper & Miller, LLP to help with its funds’ financial statements. Mohlman asked the firm to also audit the funds.
A fund manager can satisfy the Custody Rule requirements if it completes and distributes annual audited financial statements prepared in accordance with GAAP to each limited partner within 120 days of the end of the partnership’s fiscal year. The audit must be done by an independent public accountant that is registered with, and subject to regular inspection by the PCAOB. To be considered independent, a public accountant must meet the standards of independence described in Rule 2-01(b) and (c) of Regulation S-X.
KSM was already drafting the fund’s financial statements. KSM used the bank statements and other records provided to create a trial balance and then the financial statements, including the notes to the financial statements. Then it was auditing its own work.
That is certainly efficient for GAAP purposes. But it is not independent under Regulation S-X. The Custody Rule’s use of Regulation S-X imposes a higher level of independence than GAAP.
As you might guess, the reason the SEC came after KSM is because Mohlman was accused of fraud.
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