Financial Services Newsletter:
News & Trends
The SEC Custody Ruled — Compliance Insights and
Recent Fines and Sanctions
By Michael Provini, CPA, Marc Rinaldi, CPA, and Eric Gelb, CPA
On October 28, 2013, the Securities and Exchange Commission sanctioned three SECregistered investment advisory firms (RIAs) for violating the “Custody Rule.”
The custody-related deficiencies that the SEC’s National Examination Program (NEP) staff
observed can be grouped into four categories. An adviser failed to:
Michael Provini, CPA
[email protected]
212.286.2600
1.
2.
3.
4.
Recognize that it has “custody” as defined under the Custody Rule;
Comply with the rule’s “surprise exam” requirement;
Comply with the “qualified custodian” requirements; and/or
Comply with the audit approach for pooled investment vehicles.
The Custody Rule (Rule) requires RIAs to meet certain standards when maintaining
custody of their clients’ funds or securities. RIAs must comply with the custody rule if
they have legal ownership or access to client assets or have an arrangement that permits
them to withdraw client assets.
Many investment advisers hold their clients’ assets at qualified custodians, for example a
broker-dealer bank. This eliminates the need to have an internal control examination, for
example an SSAE16. However, it is still important to determine whether and how the
Custody Rule impacts the adviser.
Marc Rinaldi, CPA
[email protected]
212.286.2600
The Rule requires all advisers that hold custody over client assets to have an annual
“surprise custody examination” or “surprise custody audit.” The examination is designed
to verify the existence of client assets.
The Rule requires that advisers have a reasonable basis to believe that a qualified
custodian is sending account statements directly to fund investors at least quarterly.
Advisers with custody of hedge fund or other private fund assets may alternatively
comply with the custody rule by engaging a PCAOB-registered auditor to audit the Fund
in accordance with US GAAP, after which financial statements must be delivered to
investors in accordance with regulatory timelines.
Eric Gelb, CPA
[email protected]
914.381.8900
Recent SEC investigations found that Further Lane Asset Management, GW & Wade, and
Knelman Asset Management Group failed to maintain client assets with a qualified
custodian or engage an independent public accountant to conduct surprise exams. The
SEC issued orders instituting settled administrative proceedings against the three firms
for deficiencies related to the custody rule – Rule 206(4)-2 under Section 206(4) of the
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Contact:
New York, NY
212.286.2600
212.867.8000
Harrison, NY
914.381.8900
Stamford, CT
203.323.2400
Paramus, NJ
201.712.9800
New Windsor, NY
845.220.2400
Wethersfield, CT
860.257.1870
Investment Advisers Act of 1940. The firms also committed other violations of the federal
securities laws. Each firm has agreed to settle the SEC’s charges.
Case #1: According to the SEC’s order against Further Lane Asset Management
(FLAM) and its CEO Jose Miguel Araiz, FLAM failed to arrange an annual
surprise examination to verify the Funds’ assets. The funds’ investors also did
not receive quarterly account statements from a qualified custodian of the
funds as required by the Custody Rule. The SEC found other securities law
violations. In consenting to a censure and cease-and-desist order, Araiz, FLAM
and OGI agreed to pay disgorgement and prejudgment interest totaling
$347,122. Araiz additionally agreed to pay a $150,000 penalty and be
suspended from the industry for one year. FLAM consented to comply with
certain compliance-based undertakings.
Case #2: According to the SEC’s order against GW & Wade, the firm was subject
to the Custody Rule in part due to its practice of using pre-signed letters of
authorization and then transferring client funds without always obtaining
contemporaneous client signatures. The firm did not have proper safeguards
as a custodian of client funds, and failed to identify itself as a custodian to its
independent auditors or in public disclosures. This practice exposed clients to
potential harm and ultimately contributed to a third-party fraud in one client
account in June 2012, when someone hacked into the client’s e-mail account
and posed as the client. The imposter requested that GW & Wade wire the
client’s funds to a foreign bank, and the scheme was not discovered until three
separate wires totaling $290,000 had been sent to the foreign bank. The firm
reimbursed the client. GW & Wade additionally made inaccurate Form ADV
disclosures about the amount of client assets in custody and its custody
arrangements. In consenting to a censure and cease-and-desist order, GW &
Wade agreed to pay a $250,000 penalty.
Case #3: According to the SEC’s order against Knelman Asset Management
Group (KAMG) and its CEO and chief compliance officer, Irving P. Knelman,
KAMG had custody of the assets of a fund of private equity funds named
Rancho Partners I. However, Rancho’s funds were not subject to annual
surprise examinations and Rancho members did not receive quarterly
account statements from a qualified custodian. Alternatively, Rancho’s
financial statements were not audited or distributed to Rancho members.
The order details other violations of the securities laws, including improper
discretionary cash distributions to Rancho members, failure to adopt and
implement controls designed to safeguard client assets, and failure to
conduct annual compliance reviews. In consenting to a censure and ceaseand-desist order, KAMG agreed to pay a $60,000 penalty. Knelman agreed to
pay a $75,000 penalty and be barred from acting as a chief compliance officer
for at least three years. KAMG and Knelman also consented to compliance
training and other compliance-based undertakings.
The SEC has placed increased emphasis in its examinations of custody, client asset
safeguards and, in particular, ensuring that Funds are safeguarding client assets.
To learn more about whether your Fund may be subject to the Custody Rule and surprise
custody examinations call Eric Gelb, Michael Provini or Marc Rinaldi at 212
‐286‐2600 or
visit www.odpkf.com.
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About the firm:
The Financial Services Group of O'Connor Davies, LLP provides attest services to the investment
community, including audit and surprise custody examinations, tax, regulatory compliance
(including Dodd-Frank), performance reporting, investment valuation, due diligence, consulting and
complete fund administration. Its clients include private equity, hedge and venture capital funds,
investment advisers, family offices, private foundations and endowments, pensions, and brokerage
firms which represent more than $13.6 billion in combined assets.
O'Connor Davies, LLP is a full service Certified Public Accounting and consulting firm that has a long
history of serving clients both domestically and internationally and providing specialized
professional services of the highest quality. With roots tracing to 1891, six offices in New York, New
Jersey and Connecticut, and over 400 professionals, including 70 partners, O'Connor Davies is
ranked number 36 in Accounting Today's 2013 "Top 100 Firms" in the United States. The firm is
registered with the Public Company Accounting Oversight Board and is an independent member
firm of PKF International, Ltd., a worldwide network of accounting firms.
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