Category: Custody

SEC Sanctions CCO for Custody Rule Violations

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The Securities and Exchange Commission issued an order against Mark M. Wayne, the president, Chief Executive Officer, and Chief Compliance Officer of Freedom One Investment Advisors, Inc. for violations of the the custody rule under the Investment Advisers Act. Although that’s the headline, the SEC action shows many other compliance failures.

First, the custody issues. From 2008 through 2010, Freedom One had custody of client assets and violated the custody rule’s requirement that it have an independent public accountant conduct annual surprise exams to verify those assets. For 2008, Freedom One engaged a national public accounting firm to perform a surprise exam, but failed to follow through with its completion. For 2009 and 2010, another national public accounting firm conducted surprise exams but they were insufficient. Freedom One limited the exams to only a subset of the accounts.

In 2010, the new custody rule came into effect and required Wayne to have the custodian send account statements directly to his clients. He failed to do so.

The SEC charged Wayne with aiding and abetting and causing these violations because as CEO, a principal, and CCO of Freedom One, he took no action to ensure compliance. Apparently, he delegated responsibility for the 2009 and 2010 surprise exam to someone who had no compliance training or experience and who did not know which accounts Freedom One had custody over. Wayne approved Freedom One’s compliance manuals. Wayne he appointed recordkeeping responsibilities to someone who lacked the necessary skills and did not provide her with adequate support and training to accurately maintain Freedom One’s books and records.

Granted those actions are all violations but don’t seem so egregious that the SEC would bring an enforcement action. The order spends a few paragraphs describing some poor accounting practices, but the problem is the movement of money between the adviser and its record-keeping affiliate. The order states no improper movement of assets between the client and the adviser.

The SEC not only brought an action against the adviser, it also brought charges against the accountants who failed to complete the surprise examination in 2008.

The action shows me that the SEC is serious about custody rule compliance, even when client assets are not in danger.

References:

Updated Guidance on the Custody Rule for Private Funds

Barnum and Bailey Limited Stock Certificate

The Securities and Exchange Commission has provided some updated guidance on the Custody Rule for private funds. It has sometimes been tricky for private funds to comply with Rule 206(4)-2.

The custody rule deems it to be a fraudulent, deceptive or manipulative act, practice or course of business for an adviser to have custody of client funds or securities unless a qualified custodian maintains those funds and securities in a separate account for each client under that client’s name. The custody rule provides an exception from the custodian requirement for a fund in the case of certain privately offered securities it holds, provided the fund’s financial statements are audited.

“Privately offered securities” are defined as securities that are: (A) acquired from the issuer in a transaction or chain of transactions not involving a public offering; (B) uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and (C) transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer.

This has posed a challenge for real estate fund managers and private equity fund managers that happen to have an entity that is certificated. For example, if the real estate fund has a REIT subsidiary, it may have issued stock certificates as a matter of practice. The Custody Rule would mandate that the fund hire a qualified custodian to hold that single REIT stock certificate. That custody relationship is expensive and provides little (no?) protection to fund investors.

The Investment Management Division issued an update that provides a great deal of relief.

The Division created a new category of securities for purposes of the custody rule: “private stock certificates.” These are non-transferable stock certificates or “certificated” LLC interests that were obtained in a private placement. These fail to meet the definition of “privately offered securities” because they are certificated.

“The Division would not object if an adviser does not maintain private stock certificates
with a qualified custodian, provided that:
  1.  the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule;
  2. the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
  3. ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  4. the private stock certificate contains a legend restricting transfer; and
  5. the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.”

That is fantastic news.

Even better, the update adds some clarity to partnership agreements:

Partnership agreements, subscription agreements and LLC agreements are not certificates under Rule 206(4)-2(b)(2)(B) and the securities represented by such documents are privately offered securities provided they meet the other elements of Rule 206(4)-2(b)(2).

I know a few fund advisers that took a very conservative position on the Custody Rule and were shipping partnership agreements their custodians. It looks like that is not required by the Custody Rule.

References:

The SEC Is Not Happy with Custody Compliance

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The Securities and Exchange Commission issued a Risk Alert on compliance with its custody rule for investment advisers. Beyond the warning to investment advisers, it also issued an Investor Bulletin to protect advisory clients from theft or misuse of their funds and securities.

After a review of recent examination, the SEC’s Office of Compliance Inspections and Examinations found significant deficiencies in custody-related issues in about one-third of the firms examined that had serious deficiencies.

  • Failure to recognize that they have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services
  • Failure to meet the custody rule’s surprise examination requirements
  • Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
  • For fund managers, failures to (1) meet requirements to engage an independent accountant and (2) demonstrate that financial statements were distributed to all fund investors.

In the Risk Alert, the SEC is shares some of the custody deficiencies observed in order to assist investment advisers in complying with the custody rule.

2013 SEC Examination Priorities

SEC National Exam Program

The Securities Exchange Commission published its examination priorities for 2013. They cover a wide range of issues at financial institutions, including broker-dealers, clearing agencies, exchanges and self-regulatory organizations, investment companies, hedge funds and private equity funds, and transfer agents.

The scope of an IA examination is “generally limited to the issues and business practices of the registrant that are perceived by the staff to present the highest risks to investors and the integrity of the market. Thus, the scope of exams will vary from registrant to registrant.”

But of course there are issues that will be at the top of the list. In addition to the specific risk areas unique to each registrant, the staff will consider the following focus areas when scoping and conducting examinations in 2013 that I saw as relevant to private funds..

1. Safety of Assets.

The staff will review the measures taken by registrants to protect client assets from loss or theft, the adequacy of audits of private funds, and the effectiveness of policies and procedures in this area. Exams will focus on issues such as whether advisers are:

  • appropriately recognizing situations in which they have custody as defined in the Custody Rule;
  • complying with the Custody Rule’s “surprise exam” requirement;
  • satisfying the Custody Rule’s “qualified custodian” provision; and
  • following the terms of the exception to the independent verification requirements for pooled investment vehicles.

2. Conflicts of Interest Related to Compensation Arrangements.

The exam will look for undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fees or solicitation arrangements, and referral arrangements. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.

3. Marketing/Performance.

Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation practices. The exam will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures. Of course, the exam will test compliance with record keeping requirements by asking for the backup data.

In a surprise reference to the JOBS Act, the exam will review changes in advertising practices related to the JOBS Act, where feasible.

4. Conflicts of Interest Related to Allocation of Investment Opportunities.

Advisers managing accounts that do not pay performance fees side-by-side with accounts that pay performance-based fees face unique conflicts of interest. While reviewing portfolio management practices, the staff will confirm that the registrant has controls in place to monitor the side-by-side management of its different accounts. The exam will not want to see more profitable trades being allocated to the accounts that pay the most in fees.

5. Fund Governance.

Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination.

6. New Registrants and Presence Exams.

Approximately 2,000 investment advisers have registered with the SEC for the first time as a result of Dodd-Frank. The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC. The presence exam initiative is expected to run for approximately two years and consists of four phases: (i) engage with the new registrants; (ii) examine a substantial percentage of the new registrants; (iii) analyze our examination findings; and (iv) report to the industry on our observations.

7. Compliance with the Pay to Play Rule.

To prevent advisers from obtaining business from government entities in return for political “contributions”, the SEC implemented the Pay to Play rule. The staff will review for compliance in this area, as well as assess the practical application of the rule. Given that state and local elections are on tap for the next two years, the pay-to-play rule will be even more difficult for fund companies.

 

Custody and Private Funds

Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.

The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.

Safekeeping required

Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

(1) A qualified custodian maintains those funds and securities:

(i) In a separate account for each client under that client’s name; or

(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.

Use of a Qualified Custodian

So who can you use as a “qualified custodian“?

(d)(6) Qualified custodian means:

(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Surprise audits and custodian statements

In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.

When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.

There is an exception for pooled investment vehicles:

(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.

Certain privately offered securities

There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Notes and Interests in Subsidiaries and Portfolio Companies

For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.

For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.

Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.

In the SEC Q&A about the custody rule:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities.

So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.

At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.

Sources:

ARMOR * PLATE / ptufts / http://creativecommons.org/licenses/by-nc-sa/2.0/

More Information on the Custody Rule

With the removal of the 15 client rule exemption from registration with the SEC, many private funds are going to have to comply the custody rule Rule 206(4)-2. Private equity firms will have the most problems trying to meets the demands of the rule.

The SEC is trying to help. They updated the Staff Responses to Questions About the Custody Rule.

Apparently they have been getting lots of questions about how the surprise examination should work.

Question IV.4

Q: Is there an example of a report that may be issued by the independent public accountant performing a surprise examination of the adviser?

A: Yes. As stated within the Commission’s Guidance for Accountants (see Release No. IA 2969), the surprise examination is a compliance examination to be conducted in accordance with AICPA attestation standards. The AICPA has issued an illustrative surprise examination report to reflect the reporting specified in the Guidance for Accountants. The illustrative report is available on the AICPAs website at http://www.aicpa.org/InterestAreas/AccountingAndAuditing/Resources/
AudAttest/AudAttestGuidance/DownloadableDocuments/
FINAL_Surprise_Exam_Report_File_for_AICPA_org_REVISED_7.22.10.pdf.

Additionally, the AICPA published this illustrative surprise examination report in the May 2010 edition of the Audit and Accounting Guide — Investment Companies. (Posted September 9, 2010)

Question XIII.3

Q: Within the Guidance for Accountants contained in Release IA-2969, the Commission indicated that two types of reports issued under the AICPA professional standards (Type II SAS 70 or AT 601 compliance attestation) would be sufficient to satisfy the requirements of the internal control report. Are there other report formats that can be used to satisfy the Custody Rule?

A: Yes. The AICPA recently developed a report that under AT 101, Attest Engagements, of the AICPA’s professional standards that would be acceptable under the Custody Rule. An illustrative report is currently available on the AICPA’s website at http://www.aicpa.org/
InterestAreas/AccountingAndAuditing/Community/InvestmentCompanies/
DownloadableDocuments/Custody_report_September_1final.pdf. (Posted September 9, 2010)

Sources:

Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

Image of Old West Bank – It’s a beautiful bank is by oddsock

Custody of Funds or Securities of Clients by Investment Advisers

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The SEC released the final version of its new custody rule (.pdf). The Commissioners had announced their approval of the rule on December 17 and then released the final text on December 30. The rule goes into effect 60 days after publication in the Federal Register.

The amendments are designed to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities by requiring such an adviser, among other things: to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers.

This new custody rule is designed to catch a Madoff fraud.

The rule is limited in scope. Only SEC-registered investment advisories that control custody of their client’s assets – as Madoff did — are subject to the rule. Independent RIAs with client assets in custody with unaffiliated third parties are exempt from the final version of the rule.

The difference is that the SEC exempted investment advisers who were deemed to have custody merely because they had the authority to deduct their advisory fees from client accounts from the surprise audit requirement. The SEC also exempted pooled investment vehicles from the requirement if they have an annual GAAP audit by an independent public accountant.

Between 1,500 and 1,900 SEC-registered investment advisories provide in-house custody of securities and most of these are either broker-dealer affiliates or alternative-investment managers. This leaves well over 9,000 SEC-regulated RIAs and at least that many state-registered investment adviser firms free from the burdens of the rule. The SEC estimates the annual cost of compliance at about $8,000 a year, but TD Ameritrade estimates the cost is closer to $25,000 per year.

References:

SEC Approves New Custody Rule

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The Securities and Exchange Commission adopted the proposed Custody Rule for investment advisers originally proposed last May. (See: SEC Releases Proposed Custody Rules for Investment Advisers)

As is typical with the SEC, they announced the rule was approved before they made the final version of rule available. The rule amendments will be effective 60 days after their publication in the Federal Register.

The SEC press release highlights the two biggest changes:

Surprise Exam

“The adviser is now required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. Such a surprise examination would provide another set of eyes on the client’s assets, and provide additional protection against theft or misuse. The accountants would have to contact the SEC if they discovered client assets were missing.”

Custody Controls Review

“When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report — prepared by an accountant that is registered with and subject to regular inspection by the PCAOB — that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests. These reports are commonly known as SAS-70 reports. Requiring that the accountant be registered with and subject to inspection by the PCAOB provides greater confidence regarding the quality of these reports.”

The rules are amendments to Rule 206(4)-2 [17 CFR 275.206(4)-2], Rule 204-2 [17 CFR 275.204-2] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”), to Form ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].

References:

SEC Releases Proposed Custody Rules for Investment Advisers

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On May 14, the Securities Exchange Commission said they were proposing New Custody Rules for Investment Advisers. They summarized the proposed rules but did not release the actual text of the proposed rules.

Now the proposed rules are available in Release No. IA-2876 (.pdf). Comments must be received on or before July 28, 2009.

SUMMARY: The Securities and Exchange Commission is proposing amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. The amendments, among other things, would require registered investment advisers that have custody of client funds or securities to undergo an annual surprise examination by an independent public accountant to verify client funds and securities. In addition, unless client accounts are maintained by an independent qualified custodian (i.e., a custodian other than the adviser or a related person), the adviser or related person must obtain a written report from an independent public accountant that includes an opinion regarding the qualified custodian’s controls relating to custody of client assets. Finally, the amendments would provide the Commission with better information about the custodial practices of registered investment advisers. The amendments are designed to provide additional safeguards under the Advisers Act when an adviser has custody of client funds or securities.

The proposed rule is a sign of re-regulation in the industry. Some of the proposed rules were in place prior to 2003, when they removed through de-regulation. (Investment Advisers Act Release No. 2176, September 25, 2003 [68 FR 56692]).

The proposed rules are amendments to Rule 206(4)-2 [17 CFR 275.206(4)-2], Rule 204-2 [17 CFR 275.204-2] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”), to Form ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].