The basic premise of the Custody Rule is that registered investment advisers who have custody of
client assets must implement specific safekeeping requirements to prevent loss, misuse, or misappropriation of those assets. (Rule 206(4)-2)
For non-fund managers, there is a surprise exam requirement. For fund managers, the usual route is through audited financial statements. The Custody Rule has a strict requirement that you deliver those audited financial statements to investors within 120 days of the end of the fund’s fiscal year. The audit has to be done by independent public accountant that is registered and subject to regular inspection by the Public Company Accounting Oversight Board, and in accordance with Regulation S-X.
Audits that meet those standards are expensive and take some time to perform. Let’s face the truth, if a fund manager is having trouble getting the fund audits done on time there is likely an underlying problem.
Spruce Investment Advisors acquired the management interest in about 100 private equity funds with about $182 million in regulatory assets under management and created two funds of funds on top of them.
As you might expect with the discussion about the Custody Rule, Spruce failed to meet the requirements of the Custody Rule. The firm didn’t get the audited financial statements out on time. Easy case for the SEC to win. Send the audited financial statements out on day 121 and you’ve violated the rule.
The SEC order pokes at some allocation of expenses issues that Spruce was encountering. It looks like Spruce was paying some expenses that should have been expenses of the funds. Re-jiggering the expenses delayed the audits for the financial statements. The re-allocation was another violation with the SEC piling on that Spruce didn’t have adequate policies and procedures in place regarding the allocation of expenses.
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