ECM had investment advisory clients and managed two private funds in which some of its advisory clients invested. Based on the SEC order it looks like ECM tripped over the complexities of the Custody Rule in managing the investments.
An investment adviser has custody of client assets if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those funds or securities. Under the custody rule, an investment adviser who has custody has four main obligations:
- ensure that a qualified custodian maintains the clients assets;
- notify the client in writing of accounts opened by the adviser on the client’s behalf,
- have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients, and
- ensure that client funds and securities are verified by actual examination each year by an independent public accountant in a surprise exam.
A private fund can comply with obligations 2, 3, and 4 by having the fund audited annually and sending the audited financial statements to the fund investors with 120 days of the fiscal year of the private fund.
You don’t have to comply with custody requirement of 1 for “privately offered securities.” Those are private placements that are uncertificated and can’t be transferred without consent of the issuer. Think limited partnerships and private funds.
One problem was with what the order called “paper memberships” in the private fund. I was a bit confused by what was going on. I think the problem was that ECM was holding on to the limited partnership agreements signed by its clients who invested in the private funds.
The privately offered securities exception is only for obligation 1 of custody. You still have to comply with obligation 4 of custody and have a surprise examination.
Of course that is if you have custody. I think the problem is solved by having the partnership agreements send to the clients so you don’t have custody.
It looks like ECM also failed to have the private funds audited.
Of course this may all change when (or if) the SEC enacts the proposed Safeguarding Rule.
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