Risk Alert Issued by SEC Identifies Significant Deficiencies Involving Failure of Investment Advisers to Comply with the Custody Rule

March 19, 2013

In a Risk Alert issued March 4, 2013 by the U.S. Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”), it was revealed that “the SEC’s National Examination Program (“NEP”) has observed widespread and varied non-compliance with elements of the custody rule.” Rule 206(4)-2 under the Investment Advisers Act of 1940 (“Investment Advisers Act”), states that an investment adviser has custody of client assets if it or its related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.  The Risk Alert indicated that approximately one-third (over 140) of the recent examinations reviewed by the SEC’s National Examination Program staff included custody related issues. The Risk Alert was issued by the SEC’s Office of Compliance Inspections and Examinations to encourage registered investment advisers to review their policies and procedures and examine their practices related to the deficiencies noted in the Risk Alert to ensure that investment advisers are aware of “…their responsibilities under the custody rule to protect client assets.”

The SEC Risk Alert states, “When the NEP staff identifies the risk priority areas to focus on during an examination of an adviser, it often includes a review of the adviser’s books and records, business, and operations as they relate to the safety of its clients’ assets.” The findings from the investment adviser examinations referenced in the Risk Alert resulted in a range of regulatory actions.  These actions included remedial actions taken by investment advisers like drafting, amending or enhancing the investment advisers’ written compliance policies and procedures; changing their business practices; or devoting more resource or attention to the area of custody.  Additionally, the SEC’s National Examination Program staff made referrals to the SEC’s Division of Enforcement when appropriate.

The Risk Alert indicates that the custody-related deficiencies observed by the SEC’s National Examination Program staff can be grouped into the following four categories:

  • Failure by the Investment Advisers to Recognize They Have Custody-In the risk alert it lists seven key areas that the SEC’s National Examination Program staff observed where registered investment advisers failed to recognize that an investment adviser would be deemed to have custody. (i.e., the investment adviser’s personnel or a related person serve as a trustee or have been granted power of attorney for client accounts, the investment adviser provides bill paying services, the investment adviser manages client portfolios by directly accessing online accounts using clients’ personal usernames and passwords without restrictions, the investment adviser has physical possession of client assets, such as securities certificates, the investment adviser or a related person has signatory and check writing authority for client accounts, the investment adviser received checks made payable to the client and failed to return them promptly to the sender, or the investment adviser serves as the general partner of a limited partnership or holds a comparable position for a different type of a pooled investment vehicle.)
  • Surprise Exam Requirement-In cases where investment advisers were required to have a surprise examination, the SEC’s National Examination Program staff found deficiencies where  investment advisers failed to file a Form ADV-E within 120 days after the date of the exam chosen by the accountant as required by Rule 206(4)-2(a)(4)(i) of the Investment Advisers Act and deficiencies where there was evidence suggesting that the examinations conducted were not being conducted on a “surprise” basis.
  • Qualified Custodian Requirements-Certain registered investment advisers failed to satisfy the “qualified custodian” requirement, which requires the qualified custodian to maintain client assets in a separate account for each client under the client’s name or in accounts under the name of the investment adviser as agent or trustee for the clients, as per Rule 206(4)-2(a)(1) of the Investment Advisers Act. (i.e., client assets were held in the investment adviser’s name but not in an account that was under the investment adviser’s name as agent or trustee for the client that held only clients assets, client assets were commingled with  proprietary and employee assets into one account, securities certificates held by the investment adviser’s fund were held in a safe deposit box controlled by the investment adviser, the investment adviser did not have reasonable basis, after due inquiry, for believing that the qualified custodian was sending quarterly account statements directly to the client, or the investment adviser opened a custodial account on behalf of a client and sent account statements to the client but the account statements failed to include notification urging clients to compare the account statements from the account custodian with those that were sent from the investment adviser.)
  • Audit Approach Issues– In cases where the investment adviser acting as a general partner of a limited partnership or other pooled investment vehicle relied on the “audit approach” where the pooled investment vehicle may be audited annually and the audited financial statements must be sent to all the investors in the pooled investment vehicle within 120 days after the pool’s fiscal year end, the SEC’s National Examination Program staff found that  some investment advisers were not in compliance because: the accountant that conducted the financial statement audit was not “independent “under Regulation S-X as required by the custody rule; the audited financial statements were not prepared in accordance with GAAP; the investment adviser failed to demonstrate that the audited financial statements were distributed to all fund investors, rather than “upon request” as it appeared in many instances; the audited financial statements were not sent to investors within 120 days of the private funds fiscal year end or 180 days for fund or funds; the auditor was not PCAOB registered and not subject to PCAOB inspection;  the final audit was not performed on liquidated pooled investment vehicles; or the investment adviser requested investor approval to waive the annual financial audit of a fund but the investment adviser did not obtain a surprise examination.

As stated in the Risk Alert’s conclusion, “The [Investment] Advisers Act custody rule is designed to protect and safeguard client assets. Advisers may want to consider their policies and procedures and their compliance with the custody rule in light of the deficiencies noted in this Alert. Deficiencies in this area have resulted in actions ranging from immediate remediation to enforcement referrals and subsequent litigation.”  Investment advisers should review the Risk Alert closely and use it as a checklist to assess their investment adviser’s compliance policies and procedures and supervisory controls regarding custody of client assets.

Custody of client assets is just one of the many areas that must be addressed as part of an investment adviser’s written compliance policies and procedures.  Has your investment adviser fully customized its written compliance policies and procedures and will they meet the examiners scrutiny during a regulatory exam?  The first step to preventing regulatory violations is developing customized written compliance policies and procedures.  RIA Compliance Consultants has developed an online tool, RIA Express-Compliance Manual Drafter, to assist investment advisers with efficiently updating or developing their written policies and procedures, using this online tool, your investment adviser will complete a detailed questionnaire about your investment adviser’s personnel, business model, and changes in your procedures and practices. The answers to the online questionnaire will generate a customized written supervisory procedures and code of ethics manual, via our electronic compliance manual authoring wizard. By using this tool your investment adviser will be able to develop its initial written policies and procedures or an updated manual reflecting current regulations and revisions to your investment adviser’s existing policies and procedures. For just $695, an investment adviser can purchase a Self-Customized, Regulator Specific Manual that it will prepare using the RIA Express – Compliance Manual Drafter. To purchase this product or for more information about this product, please visit our online store here.

If your investment adviser has customized policies and procedures in place, it must periodically (at least annually for all SEC and many state registered investment advisers) review and evaluate the effectiveness of the investment adviser’s policies and procedures and their ability to prevent and detect violations of the Investment Advisers Act or similar state securities regulations.  RIA Compliance Consultant has developed a cost-effective, online tool, RIA Express-Compliance Review, to help an investment adviser review its compliance program.  RIA Express – Compliance Review is our online compliance tool that helps guide you through the process of reviewing the effectiveness of your investment adviser’s compliance program. To learn more about RIA Express – Compliance Review, click here to schedule a time to speak with one of our consultants.

To gain a better understanding of what to expect during a regulatory exam, register to attend RIA Compliance Consultants’ complimentary webinar, “Preparing for a Regulatory Exam.” During this webinar our consultants will discuss a variety of topics related to the investment adviser examination process like changes that have taken place over the past couple years; different types of investment adviser examinations, including the new “presence exams” for newly registered investment advisers; the type of information and documentation that may be requested during an investment adviser examination; and some of the common deficiencies found during the investment adviser examination process. The webinar will be presented on March 21, 2013, at 12:00 p.m. CDT. Click here to register for this complimentary webinar.

Posted by Bryan Hill
Labels: Common Deficiencies, Compliance Program, Custody, Examination, Webinar, Written Policies and Procedures