Category: Custody

The One with Fund Custody Footfault

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:

  1. ensure that a qualified custodian maintains the clients assets;
  2. notify the client in writing of accounts opened by the adviser on the client’s behalf,
  3. have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients, and
  4. 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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Custody Crackdown

Earlier this year, the SEC’s Division of Examinations published its priorities for 2022. There was a significant focus area on private funds. In particular, looking at:

“compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors”.

Earlier today the SEC announced a swath of actions against firms for custody rule failures. The charged advisors advisers failed to have audits performed or to deliver audited financials to investors in private funds in a timely manner, thereby violating the Investment Advisers Act’s Custody Rule.

The SEC added on a technical filing violation as well.

Firms are strongly encouraged to ensure their compliance with the Custody Rule and the related Form ADV reporting and amending obligations. In particular, private fund advisers registered with the SEC are reminded that per the instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), “If you check ‘Report Not Yet Received,’ you must promptly file an amendment to your Form ADV to update your response when the report is available.”

The Custody Rule for private funds have some bright lines, making it easy to comply with (if you ignore the costs of audits). It also makes failure to comply with the Custody Rule very obvious. You either deliver the audited financial statements on time or you don’t.

If you don’t deliver on time, the SEC is going to notice.

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The One with the Missing Audits

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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A Drop Box is not Good Custody

Redwood Wealth got into trouble with the Securities and Exchange Commission for missing the custody compliance issues related to an investment program.

Redwood Wealth had some of its advisory clients invest in an affiliated mortgage company. Obviously, there are some disclosure items. Presumably, Redwood Wealth took take of that adequately.

The investment was structured as loans, with promissory notes documenting the loan from the advisory clients to the mortgage company. I’m going to guess that Redwood was not used to dealing with securities that are paper securities. Speaking from experience, it’s a pain in the neck to deal with these.

The question is how you deal with the custody issue. In this case Redwood Wealth has physical possession of the notes and therefore has custody of the securities. An investment adviser is not supposed to have custody like this. It looks like Redwood Wealth placed copies of the notes in an online dropbox. That doesn’t cut it for the Custody Rule.

The other problem is that the notes were not showing up on the clients’ account statements. Again, I would guess that Redwood was not used to dealing with securities that are paper securities. That also placed the notes outside the ability of CCO to review or evaluate whether it was a proper investment for the advisory client.

The SEC is not accusing Redwood of losing client money. Just the opposite. The SEC explicitly states that no Redwood client lost money. However, the SEC still brought an enforcement action and levied a $50,000 fine against Redwood and required it to hire an independent compliance consultant.

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Risk Alert on Digital Asset Securities

The Securities and Exchange Commission’s Division of Examination has been visiting firms that have been involved in digital assets. The Division published a Risk Alert that you should read if your firm has digital assets in client accounts.

Right off the bat, the risk alert hedges on its definition of “digital assets” to say that it a particular digital asset may or may not be a security. I believe the SEC’s current position is that BitCoin is not a security. Everything else it potentially a security.

There is the usual expected requirements for investment advisers and fund managers: books and records, disclosure and custody.

Custody continues to be one of the most difficult aspects of putting digital assets in client accounts. Have fun trying to meet the custody rule requirements. Even if you do, the security around digital asset keys should keep you up at night. That’s true for Bitcoin as well, even though its not a security.

One highlight was due diligence and evaluation of the risks involved in digital assets. You really need to vet these investments like you would any other investment recommendation. I like this example of required diligence:

“that the adviser understands the digital asset, wallets, or any other devices or software used to interact with the relevant digital asset network or application, and the relevant liquidity and volatility of the digital asset)”

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Combined Financial Statements and the Custody Rule

Advisers to private funds, usually rely on the audited financial statement method to satisfy the Custody Rule. The Chief Accountant’s Office of the Division of Investment Management released a “Dear CFO Letter” last week that raises issues about using combined financial statements to satisfy the custody rule.

You may have missed this possibly important compliance change because this is not a usual source for compliance. Frankly, it’s not easy to find on the SEC Website. Go to the Accounting Matters Bibliography and scroll to the bottom of the page. Let me know if you can otherwise find it on the SEC website.

Paragraph (b)(4) of the Custody Rule permits an adviser to comply with certain aspects of the Custody Rule if an account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) is subject to an annual audit and that audit is distributed to investors within120 days of fiscal year end.

Here is what seems to be the meat of the Dear CFO Letter:

“For purposes of compliance with the audit exception, however, we do not believe an investment adviser can prepare combined financial statements for multiple PIVs in reliance solely on the common management basis in ASC 810-10-55-1B. For example, in the staff’s view, if the economics of each PIV are different and not pro rata (e.g., certain PIVs only participate in certain investments or have differing fee arrangements or rights), the combined financial statements may provide less clarity about an investor’s ownership than if separate financial statements were provided to all limited partners (or members or other beneficial owners) in each PIV.

“The staff believes that if an investment adviser uses combined financial statements to rely on the audit exception, the investment adviser should consider whether:

  • Each PIV has the same management;
  • There is clear evidence of legal ownership of each investment individually with each PIV or there are contractual agreements which clearly show the assignment of investments held on a combined basis to each PIV;
  • Investments and investment gains and losses, including income and expenses, are allocated pro rata to each PIV;
  • Each PIV has the same management fee and performance fee structure (e.g., allocations work on a combined basis, calculated based on one hurdle on the combined basis, including combined fair values and contributions/distributions);
  • The financial highlights are the same for each PIV; and
  • The combined financial statements will
    • Present a statement of changes for each PIV separately and a combined aggregate total; and
    • Provide clear disclosure of each PIV’s pro rata percentage ownership of the combined basis, total commitments of each PIV, and aggregated commitments on a combined basis.”

I think this means that many private fund managers are going to have to revisit their custody analysis. This is going to add on some legal costs and audit costs.

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Importance of Timely Audits for Private Funds under the Custody Rule

The vast majority of private funds use the audited financial statements alternative for compliance with the Custody Rule. Fund managers have custody of the fund assets. Fund investors typically demand audited financial statements from their fund managers. So the audited financial statement work well with the Custody Rule and provides some third-party verification that the manager is not misusing or misappropriating client funds or assets.

The audited financial statements alternative under the Custody Rule has three main requirements:

  1. Have the audit done by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board,
  2. Distribute the audited financial statements to all investors in the fund, and
  3. Deliver the audited financial statements within 120 days of the end of the fund’s fiscal year.

The SEC just brought an action against a New Jersey fund manager for failing to meet these three requirements of the Custody Rule.

TSP Capital in Summit, New Jersey, has been registered with the SEC as an investment adviser since 2004. TSP Capital was the manager of two private funds. The largest was Cameroon Enterprises.

According to the SEC Order, TSP Capital relied on the Audited Financials Alternative to the Custody Rule but failed to comply with the requirements from 2014 through 2018. For 2014, the audit report was mailed to investors 686 days late; for 2015, the audit report was mailed to investors 927 days late. For the following years, TSP Capital did not succeed in engaging an audit firm to audit the Cameroon Fund’s annual financial statements.

This was likely easy to catch by the SEC. On the Form ADV filing, TSP Capital had to provide information about the fund in question 7.B.(1) Private Fund Reporting. Question 23(a)(1) asks :

“Are the private fund’s financial statements subject to an annual audit?”

TSP Capital answered this as “No.” I’m sure that checking “no” instead of “yes” is a red flag for the SEC.

The SEC made no claim of misuse of clients funds in the order. This was treated merely as a footfault.

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Custody Rule Failure for Lack of Independence

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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The Sergeant Shultz View on Inadvertent Custody

There has been a problem floating around for custody for investment advisers. Custody agreement between the client and qualified custodian may permit the adviser to do things with the assets in the account that create a custody problem. The Securities and Exchange Commission had been noticing this problem and last February issued a Guidance Update that flagged it.

The SEC has issued new guidance to address the problem. And the new standard is:

The SEC has updated its Frequently Asked Questions About the Custody.

Back to the substance, it’as all about the adviser not knowing about the inadvertent custody.

“An adviser that does not have a copy of a client’s custodial agreement, and does not know, or have reason to know whether the agreement would give the adviser Inadvertent Custody, need not comply with the custody rule with respect to that client’s account if Inadvertent Custody would be the sole basis for custody.”

It seems best for an adviser to stick its head in the sand or act like Sergeant Schultz and see nothing. The adviser is not a party to the custodial agreement so the powers granted to the adviser may be outside the scope of its knowledge. This new guidance seems like an adviser can purposefully not get a copy of the agreement and shield itself from the custody rule.

With inadvertent custody, the client could force a custody violation on the adviser without its knowledge.

Now, ignorance is a defense.

The other item that caught my attention is that this was released through a new thing called an Information Update.

IM Information Updates are recurring notices regarding the activities of the Division.
The Division generally issues IM Information Updates to alert the public—including
investors and industry participants—to key developments, such as updates to Frequently
Asked Questions, technical improvements to SEC forms, and certain other staff actions.
IM Information Updates may also explain administrative and procedural matters, such as
how to most effectively communicate with the staff.
This IM Information Update does not constitute staff legal guidance and is not a rule,
regulation, or statement of the Securities and Exchange Commission. The Commission
has neither approved nor disapproved its content.

This is somehow different than the Guidance Updates that we have seen from the Division of Investment Management.

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The One with The Fake Ron Stenson

Some of the things that catches my attention with frauds and Ponzi schemes are the steps that the fraudsters will take to cover up the fraud and how they think they will escape from the fraud unscathed. The recent charges against Jeremy Drake caught my attention because of the steps he took.

The Securities and Exchange Commission has filed the charges, but Mr. Drake has not yet had a chance to refute them. I’m just using the allegations as a way to help me (and maybe you) better understand how frauds evolve.

According to the complaint, Mr. Drake worked as a registered investment adviser representative. He managed to convince a professional athlete and his wife to become his clients. (I poked around, but couldn’t find out who.) The relationship started off with a standard 1% fee.

In 2012 Mr. Drake told them they were entitled to a VIP discount on the fee. I assume (1) his clients pressed him on fees, (2) his firm did not agree to the discount, and (3) Drake lied to keep them as clients. He fed them some gobbledygook about how they were getting credits in their account from the brokerage. I can only assume that he thought he could eventually convince his firm to give the discount.

But there was no discount. The client met with Mr. Drake a year later and he once again spewed out the discounted rate. He documented the fraud by sending fake account statements stating that the clients had paid “net” rates of 0.177% and 0.15%, resulting in “net” fees of $44,994 and $34,737. They had in fact paid a 1.0% rate in both accounts, resulting in actual fees paid of $280,349 and $231,889.

At this point, you may expect that the firm could have spotted Mr. Drake’s fraud. The rep is sending the account statements instead of them coming from the custodian.

A year later, the same discussion over fees happened again and more fake documents were sent. The client’s wife first language was not English, so perhaps Mr. Drake thought he could use the language barrier to keep the fraud going. The client’s wife’s assistant was the translator.

In 2016 with a new assistant and a new accountant, the client pressed Drake again. Drake continued with the lies and fake documents. The fraud was not holding together and they pressed Drake on the fee discount. To bolster the fraud, Drake created a false persona named “Ron Stenson” whom he held out as an employee of “Charles Schwab Advisor Services” who could help explain the fee credit. He pressed a colleague into the role of Ron Stenson to answer phone call inquiries.

At this point Mr. Drake realized he couldn’t keep the fraud going. The accounts were short almost a million dollars in the fees the firm was taking compared to what he was telling the clients. I scratch my head wondering how Mr. Drake was going to get out of this. I have to assume that he hoped the firm was going to grant the discount at some point.

Should Mr. Drake’s firm caught some of this activity through email monitoring? Maybe. I’m skeptical of the effectiveness of email monitoring. It’s full of false positives, causing compliance to stare at a lot of stuff instead of spending time looking at other areas.

Theoretically, Mr. Drake’s clients should have been getting account statements directly from the  third-party custodian. That should have shown actual fees deducted and the actual positions held by the client. That is one of the key pillars of the custody rule. The client should be able to verify an advisor’s work by getting the account statement directly from the custodian or getting statements that have been vetted through a third-party auditor.

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