Teach that violation of Registered Investment Advisor Custody Rule (“RIA”) can stem from lax attention to detail.
My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation. I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company. I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania.
Having worked as the CCO for RIAs, I have been through numerous regulatory audits and examinations. Experience gives me insight into how the SEC conducts investigations and attempts to obtain enforcement actions.
After completing this case study, the participants will be able to:
- Define the Custody Rule.
- Define Form ADV.
- Understand why custody, knowingly or inadvertently, creates risk for an RIA.
- Understand what prompts the SEC to bring enforcement actions against RIAs concerning the Custody Rule.
- Identify Custody Rule best practices.
Custody Rule, Form ADV, GAAP, Fee Deduction, Audited Financial Statements Alternative
Congress created the Custody Rule, found in “Rule 206(4)-2 under the Investment Advisers Act,” primarily to protect clients from unscrupulous RIAs. The Custody Rule, under Securities and Exchange Commission (“SEC”) guidelines, requires the advisers to “undergo an annual surprise examination verifying the existence of assets or, where permissible, to distribute to investors, within 120 days of each fiscal year’s end, annual audited financial statements for the fund, prepared in accordance with Generally Accepted Accounting Principles (GAAP).” Regardless, well-intentioned RIAs may not realize that their actions may trigger the application of the Custody Rule as well. This case study will cover several such scenarios that might trigger unintentional violations.
An RIA may inadvertently have custody if a client sends the firm funds or stock certificates instead of sending them directly to the broker-dealer. The RIA must return the funds or stock certificates promptly (i.e., “within three business days after receipt”), or the firm will be viewed as having custody. When an RIA holds clients’ funds or stock certificates, even for a short period of time, it runs the risk that funds or stock certificates will be lost or misused. An RIA should never forward client funds or stock certificates directly to the broker-dealer, since this will also be viewed as having custody. An RIA may, however, temporarily hold and forward a check drawn by a client and made payable to a third party (e.g., a broker-dealer, trust company, or insurance company, etc.) without having custody of the individual’s funds. This fine line distinction can cause confusion.
A RIA’s internal policies and procedures should clarify exactly and specifically how checks will be handled. Elements of the Custody Rule make it complicated to determine if an RIA has custody over clients’ assets.
RIAs often are granted the authority to move money between like-titled or same-registered accounts. This authority enables the RIA to move cash or pay bills for the client. For the foreseeable future, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) will not treat the authority to transfer a client’s assets between the client’s accounts maintained at one or more custodians as having custody. The SEC presumes that the client authorizes the RIA in writing to make the transfers, and a copy of the authorization is provided to qualified custodians. While documentation of this authorization may not be reviewed as part and parcel of normal protocol, it’s important to maintain records as protection in the event of an investigation.
The SEC may bring enforcement actions against RIAs for not acknowledging custody on Form ADV if these like-titled or same-registered accounts are not identified specifically. Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities.
RIAs should anticipate more actions such as this since government agency investigations often focus on complicated, guideline rich areas of the law in which they more easily prevail.
For four years, “TSP Capital, a New Jersey based investment adviser, fails to timely distribute the required annual audited financial statements to investors in its largest private fund that the firm advises, thereby repeatedly violating the custody rule.” In addition, TSP Capital fails to adopt and implement written policies and procedures reasonably designed to prevent custody rule violations.
The firm is investigated, and subsequently disciplined by the SEC for violating the Custody Rule, which requires, among other things, that a firm having custody of client securities follow a set of regulations which “prevent loss, misuse, or misappropriation of those assets.”
TSP Capital represents Cameroon Enterprises, LLC Fund, a $31.5 million fund which invests in private Cameroonian agricultural assets. For four years, TSP Capital attempts to utilize the Audited Financials Alternative in place of typical independent verification requirements to comply with the Custody Rule for Cameroon Fund. Advisers to limited partnerships and other types of pooled investment vehicles are eligible to utilize the Audited Financials Alternative to provide account information to all limited partners by seeking an annual audit and distributing audited financial statements to required parties.
Provisions of the Audited Financials Alternative, however, requires advisers to engage an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”) and for audited financial statements to be distributed within 120 days of a fund’s fiscal year end. Although TSP Capital hires a PCAOB-registered firm to perform the work, statements for two fiscal years are delivered “686 and 927 days late,” respectively. In the subsequent two years, the firm fails to engage an independent public accountant.
The firm’s failure to comply with the Audited Financials Alternative and other requirements results in a violation of the Custody Rule.
TSP Capital is investigated, and subsequently disciplined by the SEC for violating the Custody Rule, which requires, among other things, that a firm having custody of client securities follow a set of regulations which “prevent loss, misuse, or misappropriation of those assets.”
The SEC also finds that TSP Capital does not adopt and implement policies and procedures to prevent violations of the Advisers Act, creating an additional compliance issue SEC’s enforcement action finds that TSP Capital violates “Section 206(4) of the Investment Advisers Act of 1940 and Rules 206(4)-2 and 206(4)-7 thereunder.
TSP Capital consents to a cease-and-desist order and a censure and agreed to pay a civil penalty of $60,000. TSP Capital’s reputation is tarnished in the process and this enforcement action will remain on the Form’s ADV in perpetuity.
Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities. The form consists of two parts.
Part 1 requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees. Part 1 is organized in a check-the-box, fill-in-the-blank format. The SEC reviews the information from this part of the form to manage its regulatory and examination programs.
Part 2 requires investment advisers to prepare narrative brochures that include plain English disclosures of the adviser’s business practices, fees, conflicts of interest, and disciplinary information. The brochure is the primary disclosure document for investment advisers and must be delivered to advisory clients.
The Form ADV is often used by prospective investors as a due diligence tool to assess and RIA’s compliance program.
If a firm subject to the Custody Rule chooses to utilize the Audited Financials Alternative rule in place of otherwise satisfying the notification and accounts statements delivery requirements, it must engage a PCAOB-registered independent public accountant to perform an annual audit of the private fund and to distribute annual audited financial statements, which are prepared in accordance with U.S. GAAP, to the private fund’s investors. Failure to comply with all provisions of the Custody Rule can result in enforcement action by the SEC.
SEC rules are rife with many such detail rich, picayune requirements. Serving as an RIA, however, is a licensed privilege and frequently very lucrative. Such detail rich, picayune requirements intended to protect and benefit investors are part of the costs and obligations required for the privilege of serving as an RIA.