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Cady Bar the Door Insight & Commentary on SEC Enforcement Actions and Related Issues

It Starts with the Custody Rule

Posted in Compliance, Investment Advisers, Investment Frauds

If you’re an investment adviser with custody of your client’s assets, is there a more important rule to be sure you’re on top of than the custody rule?  If you’re on the SEC’s IA exam staff, is there a more important rule to check for compliance than that rule?  I’m going to go out on a limb here and say the answer is no.  The custody rule prescribes a number of requirements designed to enhance the safety of client assets by insulating them from any possible unlawful activities or financial reverses of the adviser, including insolvency.  These include use of qualified custodians to hold client assets, account statements for clients detailing their holdings, and annual surprise exams by an independent CPA.  The rule has other requirements, but those three are the core pillars.

The SEC has warned advisers again and again, you’d better comply with this rule.  And the reasons are pretty clear.  If advisers can’t be careful with their clients’ assets, those assets are likely to be at risk.  The SEC doesn’t want to bring enforcement actions for innumerable frauds.  Better to catch them before they start by ensuring compliance with the custody rule if it can.

But it will if it has to, and did on April 29th when it sued Douglas Cowgill and Professional Investment Management (“PIM”) in the Southern District of Ohio.  The SEC alleged that a shortfall in a money market fund account managed by PIM was discovered when the SEC staff conducted an examination of the firm to verify the existence of client assets.  PIM had reported in account statements sent to clients that it held a total of roughly $7.7 million in a particular money market fund when in fact the account reflecting these investments held under $7 million.

The SEC also alleged that Cowgill, the firm’s president and chief compliance officer, tried to disguise this shortfall by entering a fake trade in PIM’s account records.  Cowgill allegedly provided additional fake reports to SEC staff, and later transferred funds from a cash account at another financial institution to eliminate the shortfall in the money market fund account.  But that cash account also was held for the benefit of clients, so Cowgill merely moved the shortfall from one asset holding to another to avoid detection.

The whole thing started in November 2013 when the SEC commenced an examination of the firm after learning that for four consecutive years, PIM had failed to arrange for independent verification of client assets as required by the custody rule, and had filed a notice withdrawing its registration with the SEC.

[Sigh.]  Don’t do it.  Comply with the custody rule.  If you can’t, you already have serious problems at your IA shop.  And if you’ve lost your clients’ money, tell them that and give them the chance to move on.  It’s not fraud to be an ineffective investment adviser.  But this sort of behavior – as alleged – certainly is.

UPDATE on May 16, 2014:  Yesterday, the U.S. District Court for the Southern District of Ohio issued a preliminary injunction by consent against Cowgill and PIM.  The Court also appointed a receiver for the estate of PIM.

  • Kevin Warmack

    Given the issues surrounding maintaining custody, why would any small advisor maintain custody of client assets. The best thing to do would be to make arrangements with Schwab or some other entity to handle everything.

    • Stuart Rosenthal

      Kevin – good to see your name and comments here. Chop busting – now: is Schwab the best? I know you cited and added ‘or another’? Speak with you soon.

  • http://www.secmiscellany.com/ David Smyth

    Yes. Good reasons for small advisers to be extremely careful or stay far away.