Category: SEC News

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’s Notice and Access Rules: What Do They Mean For Your Company?

noticeandaccessComputershare has put together a White Paper that they distributed through Compliance Week: An Explanation of the SEC Notice and Access Rules: What Do They Mean for Your Company? (.pdf)[For Compliance Week Subscribers]

Pamela Eng, Product Manager for Computershare Investor Services takes us through The SEC’s Shareholder Choice Regarding Proxy Materials rules in Release No. 34-56135 (.pdf) issued July 26, 2007.

[I mentioned some of my confusion about the Notice and Access Rules in SEC Requirements for Online Annual Reports and Proxy Statements. (Thankfully, the rule is not in my domain.)]

Pamela points out that there are now three ways to provide annual meeting materials to shareholders:

  • Notice Only. You can send just a notice with a link to materials on the website.
  • Full-Set. When you send the full set of printed materials.
  • Mixed Set.  When you send some and leave the rest online.

The idea behind the “notice only” delivery was to save printing and delivery costs. Theoretically, the information is more useful online because it searchable and linkable.

It seems even Pamela is not completely happy with the rule. She offers six recommendations to the SEC on how the rule could be improved.

  • Allow more flexible timing for posting online documents
    We requested that the SEC allow the online documents to be made available one or two days
    after the initial mailing has been sent, rather than on the mailing date. This would give extra
    time for companies to get their documents approved and programmed for the website.
  • Allow more time to fulfill holder requests
    The rule gives only three days to fulfill requests for registered holders, yet gives nine days
    to fulfill the requests of beneficial holders. Our recommendation was to allow six days for
    fulfillment on both sides.
  • Change the 40-calendar-day timeline
    A number of companies had problems meeting the 40-day deadline for notice-only mailings,
    which led us to request that the deadline be moved to 30 calendar days before the meeting.
    Shareholders will still have plenty of time to request materials before the meeting date.
  • Allow educational information to be included with the notice-only mailing
    Because of shareholder complaints about confusion and issuer concerns about holder
    education, we advocated the inclusion of educational information with the notice. This
    information could explain the regulations and why holders are receiving a notice.
  • Allow the voting telephone number to appear on the notice
    The SEC was concerned about possible uninformed or capricious voting by registered holders,
    who would vote without first viewing the proxy materials, so it did not allow the voting
    telephone number to appear on the notice. We believe that holders understand the issues, and
    that allowing the number to be placed on the notice will help holders better understand the
    overall process.
  • Issue an FAQ, Q&A or other written clarification of the rules
    The new notice and access rules are potentially confusing to both issuers and shareholders, and
    confusion may increase as many more companies begin the process in 2009. We asked that the
    SEC issue some written clarifications, possibly including a frequently asked questions document
    (FA Q); a question and answer bank; or, in some cases, a rewrite of the rules themselves.

Time to Make the Donuts – Krispy Kreme Executives Charged With Securities Law Violations

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The Securities and Exchange Commission announced that on March 4, 2009, it filed a Complaint in the United States District Court for the Middle District of North Carolina against three former executives of Krispy Kreme Doughnuts, Inc.: Scott A. Livengood,Chairman, President, and Chief Executive Officer, John W. Tate, Chief Operating Officer, and Randy S. Casstevens, Chief Financial Officer.

The SEC Complaint alleges that between February 2003 and May 2004, Krispy Kreme inflated its quarterly and annual earnings and omitted to disclose the impact of certain adjustments to report quarterly earnings per share that exceeded its previously announced EPS guidance by one cent. The Company under-accrued or reversed previously accrued incentive compensation expense pursuant to Krispy Kreme’s Senior Executive Incentive Compensation Plan. The under-accruals and reversals were inconsistent with the formal incentive plan and were performed to inflate the Company’s earnings to exceed the Company’s guidance by one cent. The Complaint alleges that the defendants understood the existence and significance of the under accrual and the reversals to the Company’s earnings, yet failed to disclose either to the public. Livengood and Casstevens also signed and certified Krispy Kreme filings that misstated the Company’s financial performance.

The Complaint also alleges that each of the defendants sold stock following the Company’s earnings announcement for the second quarter of fiscal 2004.

The Complaint charges:

  • Livengood with violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 and Rule 13a-14, promulgated under the Securities Exchange Act of 1934, and aiding and abetting violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder.
  • Tate with violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act and Section 13(b)(5) of the Exchange Act and Rule 13b2-1, promulgated under the Exchange Act, and aiding and abetting violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13.
  • Casstevens with violations of Section 17(a)(3) of the Securities Act and Section 13(b)(5) of the Exchange Act and Rules 13a-14 and 13b2-1, promulgated under the Exchange Act, and aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13.

On the same day the Complaint was filed, the defendants consented to orders permanently enjoining the defendants from future violations, disgorgement of ill-gotten gains with prejudgment interest, and the imposition of civil penalties against defendants. The three former executives agreed to pay a total of $150,000 in fines and $632,919 in ill-gotten gains and interest.

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In the interest of full disclosure, I used to own some Krispy Kreme stock, lost a chunk of the investment and received a paltry settlement as part of the securities class action.