More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Client Communication and Miscommunication RIA policies and procedures must specify what type of communications should be retained. The safest course of action is for RIAs to retain all communicationsto clients, from clients, and about client accounts. To comply with fiduciary obligations, communications must be thorough and not mislead.
The Securities and Exchange Commission on Monday sanctioned three SEC-registered advisory firms for violating the “custody rule” that requires them to meet certain standards when maintaining custody of their clients’ funds or securities.
SEC investigations by the Enforcement Division’s Asset Management Unit following referrals by agency examiners found that New York-based Further Lane Asset Management, Massachusetts-based GW & Wade, and Minneapolis-based Knelman Asset Management Group failed to maintain client assets with a qualified custodian or engage an independent public accountant to conduct surprise exams.
The firms also committed other violations of the federal securities laws, the SEC said, and each firm has agreed to settle the SEC’s charges.
“The heart of the relationship between advisors and their customers is the safety of client assets,” said Andrew Ceresney, co-director of the SEC’s Division of Enforcement, in a statement. “Surprise exams or procedures associated with audited financial statements provide additional safeguards against assets being stolen or misused. These firms failed to comply with their custody rule obligations, and other firms who hold client assets should take notice that we will vigorously enforce such requirements.”
The SEC notes that while the majority of investment advisors do not maintain custody of client assets, which are instead held by qualified third-party custodians like a bank or broker-dealer, advisors must comply with the custody rule “if they have legal ownership or access to client assets or an arrangement permitting them to withdraw client assets.”
The commission amended the custody rule in 2010 to require all advisors with custody to undergo an annual “surprise exam” to verify the existence of client assets.
Advisors also must have a reasonable basis to believe that a qualified custodian is sending account statements to fund investors at least quarterly, the SEC said. “Advisors with custody of hedge fund or other private fund assets may alternatively comply with the custody rule through fund audits by a PCAOB-registered auditor, after which financial statements must be delivered to investors.”
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 Investment Advisers Act of 1940.
The SEC released a detailed description of each action.
Further Lane Asset Management
According to the SEC’s order against Further Lane Asset Management (FLAM) and its CEO, Jose Miguel Araiz, despite maintaining custody of assets of hedge funds managed by FLAM and affiliated adviser Osprey Group Inc. (OGI), Araiz and 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.
FLAM and Araiz additionally engaged in fraud related to a fund-of-funds under their control. They caused the fund to acquire a promissory note from another entity that Araiz owned without informing investors in writing that the fund might acquire related party promissory notes or otherwise materially deviate from its fund-of-funds investment strategy. The order details other securities law violations, including FLAM and OGI engaging in securities transactions with advisory clients on a principal basis without providing prior written disclosure to clients or obtaining their consent.
GW & Wade
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.
Knelman Asset Management Group
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 cease-and-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.
Check out How the SEC Plans to Be ‘Everywhere’ on ThinkAdvisor.