SEC Announces Enforcement Action Against Investment Adviser for Custody Violations

The Securities and Exchange Commission announced a settled enforcement action against a registered investment adviser for violating the Custody Rule and for compliance violations associated with custody. The enforcement action, coupled with the SEC’s announcement, shows the significance that the SEC places on the safeguarding of client assets.

An investment adviser has custody when it holds client funds or securities or has the ability to obtain possession of such assets, directly or indirectly. In general, the custody rules and regulations are intended to protect client assets from misappropriation or misuse by their investment adviser. As a result, it is considered a prohibited act for an investment adviser to have custody of client funds or securities without implementing policies and procedures specifically designed to comply with the rules and regulations and prevent misuse of the assets. These policies and procedures include notice to client in certain situations, identification of the qualified custodian, and obtaining an audit or verification by an independent CPA of the client assets subject to custody. Custody can be further imparted to an investment adviser through a related party of the investment adviser.

The Custody Rule requires investment advisers who have custody of client assets to: (1) make certain that client assets are maintained at a qualified custodian; (2) provide notice to clients when a client account is opened by the investment adviser at a qualified custodian; (3) have a reasonable belief that the qualified custodian provides account statements to the client at least quarterly; and (4) ensure that, per the terms of a written agreement between the adviser and an independent public accountant, client assets are verified by a surprise examination at least once a year.[1] The independent public accountant must file an ADV-E upon completion of the examination.

In the announced matter, the SEC determined that the investment adviser was deemed to have custody due to two different situations: (1) the adviser’s principal owner served as trustee for two client trusts and (2) the adviser maintain client login information for retirement accounts held away from the advised accounts. The SEC’s examination found that the adviser’s written policies and procedures contemplated the trustee situation and the adviser correctly disclosed it had custody due to the trust in its ADV filings. However, the SEC found that adviser’s policies and procedures did not discuss the adviser maintaining client login information. As a result, the adviser did not properly disclose the custody situation created by the login credentials for several years.

The SEC’s examination further found that the investment adviser failed to engage an independent public accountant for several years after disclosing that is maintained custody of client assets. Even when the public accountant was engaged, the SEC found that the engagement was not memorialized in writing, failed to account for the “surprise” element, only included the two trust accounts, and an ADV-E was never filed.

To address the noted compliance issues, the SEC announced significant penalties against the investment adviser. The Chief Compliance Officer was required to complete 30 hours of compliance training and the investment adviser was required to provide a Certificate of Compliance that documented the steps taken to address the compliance missteps. Additionally, the investment adviser was ordered to cease and desist from further violations of the Advisers Act, the investment adviser was censured, and directed to pay $90,000 in civil penalties.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.

[1] See Rule 206(4)-2.

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