Category: Custody

Inadvertently Obtaining Custody

The concept behind the custody rule is simple. The adviser needs to hold client assets safely and needs a third -party to verify that the adviser is actually holding the assets. But as it’s been put in place, the Custody Rule is complicated. At times the SEC has needed to provide guidance, and then provide further guidance  to the guidance.

In fairness, part of the problem is that there are so many different business models employed by registered investment advisers that it is hard to have things work for all of them.

The latest guidance under the Custody Rule has to do with some of the arrangements in place between advisers and their custodians. It turns out that some standard custody agreements grant advisers broader access to client funds and securities than the advisers’ agreements with their clients.

The SEC’s Division of Investment Management issued a Guidance Update discussing situations when an investment adviser may inadvertently have “custody” of client assets pursuant to Rule 206(4)-2 under the Advisers Act of 1940.

The Guidance warns advisers to look for custody agreements that permit an adviser to instruct the custodian to disburse or transfer assets. That creates “custody” even if the adviser does not actually give those instructions or the advisory agreement with the client does not permit the adviser to do so.

The fix? The Guidance says to send a letter to the custodian that limits the adviser’s authority and to have the client and custodian provide written consent to acknowledge the arrangement.

The way I read that is to fix the custody agreement.

Staying on the custody theme, the SEC staff issued a no-action letter to the Investment Adviser Association on the use of a standing letter of authorization with a client to transfer assets to a designated third party.

The SEC takes the position that a SLOA grants access to the client’s assets. The transfer instructions come from the client, but the adviser is involved so that invokes custody.

To fix that custody problem, the SEC lays out seven steps that need to be implemented and requires a n update to Form ADV Item 9 next year.

One theme is that the SEC is indicating a willingness to provide relief under the Custody Rule when an adviser has taken steps to mitigate the mitigate potential harms to its clients by these Custody Rule foot-faults.

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So Many Wrongs…

I tripped across an enforcement case that was so full of wrong things that I had to re-read it. In one sense, I saw a clever way to exploit an investment feature. On the other hand, the whole investment felt morally wrong, was deceptive and violated at least one important rule under the Investment Advisers Act.

grim reaper

Given my station in life, I had not come across bonds with a “survivor option.” It’s a feature that allows an investor’s heirs to redeem the bonds at par value upon the investor’s death. It’s an attractive investment feature for older investors who are concerned that rising interest rates will hurt the value of their bond holdings. The survivor option allows a bond to be redeemed at face value. If the bond has decreased in value because of higher interest rates, the investor’s principal is protected at death.

If you are clever, terminally ill, and want to leave cash to your heir, there is a way to exploit this feature.

Step one: find some bonds with a survivor option that are trading at a discount.
Step two: buy those bonds.
Step three: die quickly.
Step four: have your heir redeem the bonds at face value, turning the purchase discount into a gain.

If you are morally challenged and have a terminally ill family member, perhaps you could convince them to make this investment for your benefit.

If you are morally challenged and want to make some money, you could seek out terminally people, befriend them, open a joint account and invest together in the bonds.

If you are Donald Lethen, as least according to the Securities and Exchange Commission, you could raise capital to do this and break a bunch of security laws in the process.

According to the SEC Order, Mr Lethen created an investment fund managed by his Eden Arc Capital Management firm to invest in these bonds with survivor options.  He  used contacts as nursing homes and hospices to find patients with less than six months to live. He gave them a fee and then opened joint accounts with the patients to invest in the bonds with survivor options that were trading at a discount.

The SEC alleges that Mr. Lethen was merely a nominee for the investment fund that had funded the purchase of the bond. The fund could not be joint account owner and receive the survivor benefits. Mr. Lethen himself was the joint owner of the account funded with the investment fund’s money to buy the bonds.

Let me know if you see the Investment Advisers Act rule violation.

Let’s look at the other issues while you think about it.

Mr. Lethen does not seem to be misleading the patients. They get paid for their involvement in the scheme.

He may be misleading the bond issuers. That would depend on the wording of the survivor option. Mr. Lethen was the named joint account holder. It’s not clear if he was making untrue statements to exercise the survivor option.

Back to the Advisers Act issue. Do you see the problem?

The Custody Rule.

Mr. Lethen is putting the fund money into a joint account controlled by Mr. Lethen. The account was not in the fund’s name or controlled by the fund’s general partner/investment manager. Mr. Lathen failed to custody the fund assets in accounts in the fund’s name or in an account that contained only fund assets controlled by the fund manager.

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The Grim Reaper On a cottage in Netton Street. Copyright Maigheach-gheal and licensed for reuse under this Creative Commons Licence

 

Broker-Dealer Customer Protection Rule versus Investment Adviser Custody

A recent enforcement case highlighted the stark difference between the custody requirements of a broker-dealer and an investment adviser. Merrill Lynch was smacked with over $400 million in disgorgement and penalties for putting customer assets at risk.

Custody hands holding cahs in handcuffs

Private fund managers and investment advisers are well aware of the limits on the custody. The purpose is to keep customer assets safe in the event the investment adviser goes out of business or its malfeasance.

On the broker-dealer side it’s the Customer Protection Rule under Section 15(c)(3) of the Securities Exchange Act and Rule 15c3-3 thereunder. The Customer Protection Rule is designed to protect clients in the event of a broker-dealer failure from a delay in returning a customer’s securities or a shortfall in which customers are not made whole. Rule 15c3-3(e) requires a broker-dealer to maintain a reserve of funds or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers.

Fortunately, Lehman Brothers was in compliance with the rule in the fall of 2008 so its customers were made whole.

Merrill Lynch was not in compliance with the rule at times between 2009 and 2015. By violating the rule, the firm was able to finance its own trading activities by keeping fewer reserves for customer cash. The SEC dismissed some options trade that it deemed to lack economic substance allowing the firm to artificially reduce the amount of customer cash required in the firm’s reserve accounts.

“The rules concerning the safety of customer cash and securities are fundamental protections for investors and impose lines that simply can never be crossed,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.  “Merrill Lynch violated these rules, including during the heart of the financial crisis, and the significant relief imposed today reflects the severity of its failures.”

Merrill Lynch did not lose any customer cash. But the cash was at risk if the firm failed. It was at risk because the firm failed to follow the rules for protecting that cash.

Both the Customer Protection Rule for broker-dealers and the Custody Rule for investment advisers are complex. Most of that complexity is at the edges to deal with specific situations. One should not get lost in following the the reason behind the rules: protecting the clients’ funds and assets.

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Custody Rule Gotcha on PCAOB “Registered and Subject to Regular Inspection”

A friend in the private fund compliance community just came up with another “gotcha” under the Custody Rule. His client used an auditor that was registered with PCAOB, but had not yet been inspected. He thought it was enough to be registered, while waiting for an inspection. An SEC examiner argued that the auditor needed to be inspected.

It turns out, neither one was right.

Custody hands holding cahs in handcuffs

He and the examiner took a deep dive into the meaning of “subject to inspection” regarding the custody rule. Even thought the SEC used “subject to inspection” in the Custody Rule, it is not defined anywhere by the SEC. It turns out it was up to PCAOB to define “subject to inspection” in the PCAOB rules.

PCAOB says that you are an “inspected firm” if you have audited at least one issuer of public securities. Otherwise, PCAOB does not inspect that auditor. It is outside it’s statutory authority.

“The Sarbanes-Oxley Act authorizes the PCAOB to inspect registered firms for the purpose of assessing compliance with certain laws, rules, and professional standards in connection with a firm’s audit work for clients that are “issuers,” as that term is defined in the Act,* and (following amendments to the Act in 2010) a firm’s audit work for clients that are securities brokers or dealers. Many PCAOB-registered firms perform no such work, and the work they do perform is not within the scope of the PCAOB’s statutory responsibility and authority to assess. The PCAOB does not inspect those firms.”

The SEC takes that to mean that they are not therefore “subject to regular inspection”.

This is terrible result for private fund managers.

You can search for registered auditors on the PCAOB website. It shows the firm’s registration and which of the five categories the firm falls under. You need an “A” to see that the firm has audited at least one public company.  A “C” audit of a broker-dealer will also work. It looks like a “B”, “D”, or “E” will be a problem.

This dovetails into the other technical issue I noted in the Custody Rule regarding “independence.” That definition also refers to the public company reporting side under Regulation S-X. That standard of independence is higher than the independence standard contractually required by investors under fund documents.

Unfortunately, this is a cautionary tale for a fund manager using a smaller auditor. The firm may be registered with PCAOB, but if its practice does not include public companies or broker/dealers, the firm may not meet the standards of the Custody Rule for audited financial statements. Check the PCAOB website.

SEC Brings Charges Against CCO for Custody Failure

Last week at the Coping With Regulatory Failure conference, representatives from Securities and Exchange Commission repeated the SEC’s line that the SEC is not after compliance officers. But yet another case of CCO liability came out and this one kicks the CCO out of the industry and levels a $60,000 fine.

Failure stamp over white background. High detail in high resolution.

The SEC panelists repeated the line that the SEC only goes after CCOs in three circumstances:

  1. The CCO participated in the fraud
  2. The CCO hinders the exam or investigation
  3. Wholesale failure of the CCO

It’s the “wholesale failure” standard that has left many CCOs wondering if the SEC understands that term.

With a new enforcement action ruling out that pins liability on the CCO I thought it was worth a look to see if it meets the SEC standard.

The SEC announced charges against Sands Brothers Asset Management last year. The charge itself was a fairly technical violation of the Custody Rule. Sands Brothers managed private funds. 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.

That’s not good. But it is a bit technical.

The really bad part is the SEC has been after the firm to fix this problem for years. Sands Brothers and its co-founders first landed in trouble in 1999. The exam noted a deficiency for custody rule procedures. The firm thought it did not have custody, but as a manager of a private fund, it does have custody.

Sands Brothers landed in trouble again 2010 when the firm was the subject of an enforcement action for custody rule violations. The firm failed to submit an adequate audit and did not timely distribute audited financial statements.

“There is no place for recidivism in the securities markets… so now they [the Firm] face more severe consequences,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.

So it’s hard to have any sympathy for the firm for the Custody Rule violations.

But what about the CCO? These are the factors that apparently caused the CCO to be a “wholesale failure.”

  • The CCO knew or was reckless in not knowing about, and substantially assisted,
    SBAM’s violations of the custody rule. (The CCO had executed the notarized offer of settlement to enter into the 2010 Order on behalf of Sands Brothers.)
  • The compliance manual tasked the CCO with “ensur[ing] compliance with the restrictions and requirements of Rule 206(4)-2 adopted under the Advisers Act.”
  • Kelly engaged the auditors for full audits (but not surprise examinations)
  • The CCO signed representation letters to, and was a principal contact for, the auditors.
  • The CCO knew that the audited financial statements were not being distributed on time.
  • The CCO implemented no policies or procedures to ensure compliance with the custody rule – even after the 2010 Order and after Sands Brothers continued to miss its custody rule deadline year after year.
  • The CCO simply reminded people of the custody rule deadline without taking any more substantial action.
  • The CCO did not make any attempt to notify the staff of the Commission of any difficulties Sands Brothers was encountering in meeting the custody rule deadlines.

It’s hard to have much sympathy for the CCO in this situation. The Principals of the firm were also subject to bar and monetary fines, so the CCO was not singled out.

The ALJ decision had blamed the CCO for being “reckless” for not doing more to prevent the custody violations. The Settlement Order with the COO also said that he “knew or was reckless in not knowing about” the custody violations.

If we go by the SEC’s earlier standard, then the SEC is equating “reckless” with “wholesale failure.” It would have been much better for the SEC to use the standard is has been espousing: “wholseale failure”; rather than using the “reckless” standard in the order.

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Failure is from Graphic Leftovers under license

A New Exception to the Custody Rule

custody and private funds

The Custody Rule can be difficult for private equity and real estate fund managers to navigate. When I see some regulatory relief or clarification I hope for the best. 16th Amendment Advisors received relief for one of its funds based its particular circumstance Could that relief may be useful for other fund managers?

That’s not likely to be true. The fund’s sole investor are the firm’s principals. The Securities and Exchange Commission agreed in a new “no-action” letter that the firm does not have to comply with independent verification and account statement delivery provisions of clauses (a)(2), (a)(3) and (a)(4) of the Custody Rule in connection with that fund.

While the adviser does have custody of the assets in that fund, requiring a surprise exam or an annual independent audit would seem to be an unnecessary expense given that the people who control the adviser are the only investors in the fund.

The conditions the SEC recognized in giving the relief were:

  1. All investors have easy access to information (either statutory, contractual or some combination of the two) concerning the management of adviser, the Funds and each of the Fund’s general partners;
  2. All investors are listed as “control persons” in Schedule A to Form ADV because of their status as 16th Amendment’s officers or directors with executive responsibility (or having a similar status or function;
  3. All investors have a material ownership in the fund; and
  4. Investors, their spouses, children, and investment vehicles established for the individual or joint benefit of them are the only investors in the fund.

This relief is useful for feeder funds for ownership by the principals in the fund. It may be too narrow for a broader employee ownership vehicle.

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More on the SEC and Funds’ REIT Subsidiaries

reit stock certificate

I discovered some additional information about the SEC’s position on the application of the Custody Rule to the REIT subsidiaries of private real estate funds. A few months ago, a real estate fund was undergoing an SEC exam and the examiners focused on custody. The examiners used the June 2014 Guidance on SPVs to take the position that the fund must issue audited financial statements to the accommodation shareholders in the REIT subsidiaries.

I discovered that the SEC office involved in the exam was the Philadelphia office. So real estate funds in Delaware, Maryland, Pennsylvania, Virginia, West Virginia, and the District of Columbia should be especially focused on this issue.

Second, I discovered that the firm disagreed with the SEC’s position (obviously) and fought the deficiency through several rounds. Ultimately, the firm apparently decided to cede to the SEC’s position. I assume the firm decided the cost of obeying was less than the cost of fighting. Too bad.

The IM Guidance Update 2014-07 was a poorly put together document from the SEC. The key problem with the Guidance is Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investment vehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply with the custody rule because it is a separate advisory client.

Many people (and apparently SEC examiners) skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion in the Guidance

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian and a surprise exam.

I don’t have the details on how that firm used REITs in its structure. The deficiency jumps right into the position that the REITs are advisory clients. But it also makes an overly broad statement:

“[T]his guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

That is not what the Custody Rule requires and it is not what the Guidance on the Custody Rule requires.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

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SEC Demanding Audited Financial Statements for Funds’ REIT Subsidiaries

reit stock certificate

The Custody Rule is a well intentioned beast of regulation designed to prevent investment advisers from stealing money from their clients. The Rule works well for retail investment advisers and most hedge funds. It starts falling apart for private equity funds and real estate funds. The Securities and Exchange Commission tried providing some additional guidance in June with its IM Guidance Update 2014-07. Unfortunately, I think the guidance only made it more confusing for funds trying to comply with the rule and the examiners trying to do their jobs in the field.

The problem with the Guidance was Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investmentvehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply withe custody rule because it is a separate advisory client.

Many people skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion.

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian.

Getting back to the headline, one question for real estate funds has been what to do with REIT subsidiaries in the fund structure. This was also an issue pre-Dodd-Frank in deciding whether to include them as clients in determining whether you had reached the old 15-client threshold.

The subsidiary REITs could fit into the bucket of scenario 4. The fund is an investor in the subsidiary REIT and there are third party owners in the REIT. One of the requirement of REIT status is that you must have at least 100 shareholders. Since it’s a subsidiary, the fund manager is focused on its interest and typically uses accommodation shareholders to fill in the other 99 slots. I remember in my early years of practice that REITs would round up lawyers, accountants, family and friends to fill in the empty slots. Now, third party vendors will fill up those slots.

Those 100 accommodation shareholders get a preferred return paid to them, but have no interest in the ultimate economics of the REIT subsidiary. The accommodation shareholders collect their annual payment but have no concerns about investment performance. The current market rate is about 12% on their $1000 investment. They get their $120 a year and then the $1000 back at the end of the fund life.

In speaking with a group of real estate fund CCOs we discussed what their approach is for subsidiary REITs under the Custody Rule. We were startled to learn that the SEC had recently issued a deficiency letter to another real estate fund manager during an SEC exam for failing to issue audited financial statements for the REIT subsidiaries. From a redacted copy of the deficiency letter:

“This guidance [IM Guidance Update 2014-07] does not contemplate whether a client pays fees to the investment adviser, because entities are not required to pay advisory fees in order to be considered investment advisory clients. Accordingly, this guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

I think this is a shocking overreach by those SEC examiners. They seem to skip right over Footnote 10 and its assumption for purposes of the guidance that the investment vehicle, in this case the subsidiary REITs, are advisory clients.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

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Custody Rule Enforcement

SEC Seal 2

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.

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New Guidance on the Custody Rule for SPVs and Escrows

walt-disney-company-stock certificate

The Securities and Exchange Commission’s Division of Investment Management recently released updated guidance on the Custody Rule. Private funds, especially private equity funds, have been wrestling with the SEC’s Custody Rule. The rule clearly comes from the perspective of regulating retail investment advisers and hedge funds. It fails to deali n a useful manner with investments in assets that are not publicly traded. The SEC has been retreating from its latest version of the rule and trying to clarify its overly broad requirements.

The latest guidance (IM Guidance Update 2014-07) tries to add some clarity around the special purpose vehicles for investments and post-closing escrow accounts.

Last summer, the SEC tried to provide some clarity under the Custody Rule for private stock certificates, which was supposed to provide additional relief from the SEC’s overly narrow definition of “privately offered securities.” That guidance made it easier for private equity funds to comply with the Custody Rule without having to wastefully warehouse documents with banks to meet the strict boundaries of the rule.

But there is still lots of uncertainty around the Custody Rule. Compliance with custody is important. It’s a key control for consumers to make sure that their investment adviser is not stealing their money or investing it contrary to their requirements. Last year, the SEC announced that 1/3 of firms examined had custody rule problems.

For a private funds the question will arise as to who is the client for purposes of the Custody Rule when it comes to special purpose vehicles for investments. The new guidance answers questions using four scenarios where SPVs may be involved as fund subsidiaries.

The guidance provides that its okay to not treat the SPV as a separate client, but merely as an asset of the fund, as long as the fund or funds controlled by the same adviser are the owners of the SPV. The SEC states that an SPV owned by the fund and third parties would fall outside this. I’m a bit confused because I never thought an entity with multiple unrelated owners would be considered an SPV.

The guidance also tackles post-closing escrow accounts. The concern is that the escrow account would hold cash owed to the fund, as well as other sellers not related to the fund. The problem is that the Custody Rule requires the client’s assets to be in an account in the client’s name and contain only the client’s funds or securities. A mixed post-closing escrow would violate the rule.

In the Guidance, the SEC retreats from commingling requirement so long as:

  • the fund is audited
  • the commingled escrow is in connection with sale or merger of a portfolio company
  • the escrow is maintained by a qualified custodian

The Guidance fixes some problems and creates some more. The rule clearly states that commingling is never allowed. The guidance now says that commingling is allowed in certain circumstances. Good luck reading the published regulations.

The SEC has just laid down the law on how post-closing escrows are handled in private equity transactions. I can hear the screams now that the Guidance does not match up with how the deals are structured or how the escrow is designed. Of course for real estate fund managers, they are left scratching their heads trying to figure out how to make this exception work for them.

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