An investment adviser has custody of client assets if it holds, directly or indirectly, client funds or securities, or if it has the authority to obtain possession of those assets.[1] An investment adviser with custody of client assets must:
- ensure that a qualified custodian maintains the client assets;
- notify the client in writing of accounts opened by the adviser at a qualified custodian on the client’s behalf;
- have a reasonable basis for believing that the qualified custodian sends account statements at least quarterly to clients, except if the client is a limited partnership or limited liability company for which the adviser or a related person is a general partner or managing member, the account statements must be sent to each limited partner or member; and
- ensure that client funds and securities are verified by actual examination each year by an independent public accountant at a time chosen by the accountant without prior notice or announcement to the adviser.
See Advisers Act Rule 206(4)-2(a)(1)-(5) commonly referred to as the “custody rule.”
The custody rule provides an alternative to complying with the requirements of Advisers Act Rule 206(4)-2(a)(2), (3) and (4) for investment advisers to limited partnerships, limited liability companies, or other types of pooled investment vehicles. The custody rule provides that an investment adviser “shall be deemed to have complied with” the independent verification requirements and is not required to satisfy the notification and account statements delivery requirements with respect to a fund if the fund is subject to audit at least annually and “distributes [the fund’s] audited financial statements prepared in accordance with generally accepted accounting principles or GAAP to all limited partners… within 120 days of the end of [the fund’s] fiscal year” (“Audited Financials Alternative”).[2] The accountant performing the audit must be an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”).[3] An investment adviser to a limited liability company that fails to meet the requirements of the Audited Financials Alternative to timely distribute audited financial statements prepared in accordance with GAAP would need to satisfy all of the requirements of Rule 206(4)-2(a)(2)-(4) in order to avoid violating the custody rule.
The custody rule as discussed above continues to be fertile ground for regulatory examinations by the Securities Exchange Commission (“SEC”). To that point, recently the SEC lodged charges against five investment advisers for various violations of the custody rule. These charges include the investment advisers’ failure to:
- have audits performed;
- deliver audited financials to investors in a timely manner;
- ensure a qualified custodian-maintained client assets;
- promptly file amended Forms ADV to reflect they had received audited financial statements; and
- properly describe the status of its financial statement audits for multiple years when filing its Form ADV.
In this month’s Risk Management Update, we’ll take a look at the recent SEC charges related to custody rule violations, in an effort to ensure your firm is aware of, and in compliance with, the custody rule.
In the Matter of Lloyd George Management (HK) Limited or “LGM”
LGM is an investment adviser to private funds. A related person of LGM has served as the managing member or general partner of the subject Fund with the authority to make decisions for and act on behalf of the Fund, and thus is deemed to have custody of the Fund’s assets as per Advisers Act Rule 206(4)-2. Although LGM purported to rely on the Audited Financials Alternative in order to comply with the custody rule for the Fund, they failed to satisfy the following requirements:
- no timely delivery of the audited financials for years ending 2017 through 2021 to Fund investors;
- these audits were completed pursuant to the International Standards on Auditing, not U.S. GAAS requirements or generally accepted auditing standards; and
- non-registration with PCAOB of the auditor that performed the fiscal year-end 2021 audit.
Accordingly, LGM did not satisfy the requirements of the exception and was obligated to comply with the custody rule which LGM failed to do. LGM was ordered to pay a civil money penalty in the amount of $50,000.
In the Matter of Bluestone Capital Management, LLC or “Bluestone”
Bluestone is an investment adviser to private funds. A related person of Bluestone has served as the managing member or general partner of the subject Fund with the authority to make decisions for and act on behalf of the Fund, and thus is deemed to have custody of the Fund’s assets as per Advisers Act Rule 206(4)-2. Although Bluestone purported to rely on the Audited Financials Alternative in order to comply with the custody rule for the Fund, they failed to timely deliver audited financials for years ending 2018 through 2021 to investors of the Funds. Accordingly, Bluestone did not satisfy the requirements of the exception and was obligated to comply with the custody rule which Bluestone failed to do.
Bluestone also failed to amend information in its Form ADV to include Section 7 and Schedule D of Form ADV Part 1A surrounding relevant questions for years 2017 through 2022 to update and amend these responses in the Forms ADV to properly describe the status of its financial statement audits. Bluestone was ordered to pay a civil money penalty in the amount of $75,000.
In the Matter of The Eideard Group, LLC or “Eideard”
Eideard is an investment adviser to private funds. A related person of Eideard has served as the managing member or general partner of several subject Funds with the authority to make decisions for and act on behalf of all Funds, and thus is deemed to have custody of the Funds’ assets as per Advisers Act Rule 206(4)-2. Eideard failed to maintain securities of certain private funds that it advised with a qualified custodian. Moreover, they failed to conduct and timely distribute annual audited financial statements prepared in accordance with GAAP to investors in certain private funds that it advised. These failures resulted in violations of Section 206(4) of the Advisers Act. Eideard was ordered to pay a civil money penalty in the amount of $80,000.
In the Matter of Disruptive Technology Advisers LLC or “DTA”
DTA is an investment adviser to private funds. A related person of DTA has served as the managing member or general partner of several subject Funds with the authority to make decisions for, and act on behalf of the Funds and thus is deemed to have custody of the Funds’ assets as per Advisers Act Rule 206(4)-2. DTA purported to rely on the exception to the qualified custodian requirement that is only available for certain privately offered securities. That exception under section (b)(2) of the custody rule commonly referred to as the Privately Offered Securities Exception only extends to pooled investment vehicles, including DTA’s Funds, when such pooled investment vehicles are audited and audited financial statements are distributed as described under Advisers Act Rule 206(4)-2(b)(4). DTA failed to obtain an audit of the Funds and distribute audited financials of Funds to the investors as required by the exception. Accordingly, DTA did not satisfy the Privately Offered Securities Exception and was obligated to comply with the custody rule which DTA failed to do.
DTA also failed to amend information in its Form ADV to include Section 7 and Schedule D of Form ADV Part 1A surrounding relevant questions for year 2022 to update and amend these responses in the Forms ADV to properly describe the status of its financial statement audits. DTA was ordered to pay a civil money penalty in the amount of $225,000.
In the Matter of Apex Financial Advisors Inc. or “Apex”
Apex is an investment adviser to private funds. A related person of Apex has served as the managing member or general partner of several subject Funds with the authority to make decisions for, and act on behalf of the Funds and thus is deemed to have custody of the Funds’ assets as per Advisers Act Rule 206(4)-2. Although Apex purported to rely on the Audited Financials Alternative in order to comply with the custody rule for the Funds, they failed to timely deliver audited financials for years ending 2019 through 2021 to investors of the Funds. Accordingly, Apex did not satisfy the requirements of the exception and was obligated to comply with the custody rule which Apex failed to do.
Apex also failed to amend information in its Form ADV to include Section 7 and Schedule D of Form ADV Part 1A surrounding relevant questions for years 2020 and 2021 to update and amend these responses in the Forms ADV to properly describe the status of its financial statement audits. Apex was ordered to pay a civil money penalty in the amount of $130,000.
In Conclusion
“The Custody Rule and the associated Form ADV reporting obligations are core to investor protection” as stated on September 5, 2023, by Andrew Dean, the Co-Chief of the SEC Enforcement Division’s Asset Management Unit. Mr. Dean further stated that the SEC “will continue to ensure that private fund advisers meet their obligations to secure client assets.” Advisers must routinely review, refine, and improve, as appropriate, their business operations for the applicability of the custody rule so as to prevent the loss, misuse, or misappropriation of client assets. The Core Compliance & Legal Services, Inc. consulting team are well versed in this area and can assist with potential custody violations. Call or email us at 619-278-0020 or info@corecls.com for more information.
Author: Maggie Tavares, Sr. Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
[1] See Advisers Act Rule 206(4)-2(d)(2).
[2] See Advisers Act Rule 206(4)-2(b)(4).
[3] See Advisers Act Rule 206(4)-2(b)(4)(ii).