The SEC can express its displeasure with a particular securities practice in a number of different ways, with increasing levels of fun for the alleged malefactor. Here’s a non-exhaustive list:
- One thing it can do is file an enforcement action in federal or administrative court. This option is not fun at all. It’s not as bad as a criminal action, but in the SEC context, it doesn’t get worse than a public accusation that one has broken the law and must pay, one way or the other.
- The SEC can also issue what it calls a “Report of Investigation” under Section 21(a) of the Exchange Act. This option, somewhat rare, is a little bit more fun. It happens when the legal context of an investigation is not sufficiently clear to file an enforcement action, but the SEC still thinks it important to address the (mis)conduct publicly. Here, the SEC identifies the people and entities involved, publicly pronounces the problems it sees with the conduct, and essentially says, sin no more. No sanctions are imposed, and the people can go on their way.
- Another thing the SEC can do is issue a Risk Alert. The Commission specifically addresses a securities practice that bothers it, tells everyone to stop it, and moves on. This option is, all told, pretty fun. The conduct described can be fairly serious, but none of the potential wrongdoers are identified, and everyone can pretend the bad eggs are other people. Fun!
The SEC took the third option on Monday, when its Office of Compliance, Inspections, and Examinations issued a Risk Alert titled Significant Deficiencies Involving Adviser Custody and Safety of Client Assets. At issue was the investment adviser custody rule, Rule 206(4)-2 under the Investment Advisers Act of 1940. Notably, about a third of recent examinations revealed significant deficiencies among registered investment advisers in their compliance with the rule. Hence, the risk alert.
What the Custody Rule Requires
As the alert noted, an investment adviser has custody of client assets if it holds client funds or securities or has any authority to obtain possession of them. If so, what does the adviser have to do? The custody rule’s function is basically preventative. The idea is that compliance with it will keep misappropriation or other misconduct from ever happening in the first place. To that end, the custody rule prescribes a number of key safeguards:
- Use of “qualified custodians” to hold client assets. Assets generally must be maintained at a bank or broker-dealer, in an account that is not commingled with the adviser’s assets;
- Notice to clients. An adviser that opens a client account at one of those qualified custodians must let the client know about it;
- Account statements. An adviser must reasonably believe that the qualified custodian is sending the client account statements at least quarterly;
- Annual surprise exams. Advisers with custody of client assets must undergo an annual surprise exam by an independent public account that verifies those assets;
- Additional protections for related qualified custodians. If the adviser’s related person acts as the qualified custodian, the annual surprise exam must be conducted by an accountant registered with the PCAOB, who each year must report on the internal controls relating to custody of client assets.
- Audit approach for pooled investment vehicles. With this approach, the adviser distributes annual audited financial statements to investors. This approach obviates compliance with account statement delivery obligations, as well as the surprise exam requirement.
Deficiencies Identified by the SEC
The SEC’s staff found many problems in its recent exams of investment advisers, and grouped them into four general areas.
- Adviser’s failures to recognize they have custody. These failures took many forms. One listed example notes that an adviser that serves as the general partner of a pooled invest investment vehicle generally has custody of client assets because the position gives legal ownership or access to client funds and securities.
- Surprise exam requirement. The SEC found evidence that some of these “surprise” exams were not really surprises at all. That is to say, if you know your exam is going to happen on June 1st of each year, it isn’t a surprise.
- Qualified custodian requirements. Again, the deficiencies were legion. At times, advisers held paper stock certificates in a safe deposit box controlled by the adviser at a local bank. In other instances, the advisers commingled client, proprietary, and employee assets in one account.
- Audit approach issues. Some advisers relying on the audit approach failed to demonstrate that audited financial statements were distributed to all fund investors. Others’ audited financial statements were not prepared in accordance with GAAP. Here, too, advisers found other ways to violate the rule as well.
If you are a registered investment adviser, read the alert, figure out your weaknesses, and take steps to fix them. If you do not, an enforcement action might be waiting right around the corner. And that won’t be fun at all.