Three advisory firms have been sanctioned by the SEC for violating the custody rule that requires them to meet certain standards when maintaining custody of their clients funds or securities.
New York-based Further Lane Asset Management; GW & Wade, a Focus Financial Partners firm in Massachusetts; and Minneapolis-based Knelman Asset Management Group all failed to maintain client assets with a qualified custodian or hire an independent public accountant to conduct surprise exams, according to the SEC. The firms also committed other violations of federal securities laws, the SEC added. Each firm agreed to settle the charges.
The heart of the relationship between advisers and their customers is the safety of client assets, says Andrew Ceresney, co-director of the SECs Division of Enforcement. 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.
NO SURPRISE EXAMINATIONS
According to the SECs order against Further Lane and its CEO Jose Miguel Araiz, despite maintaining custody of assets of hedge funds managed by the firm and affiliated adviser Osprey Group, Araiz and Further Lane 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 charged. Further Lane and Araiz additionally engaged in fraud related to a fund-of-funds under their control and other securities law violations.
Consenting to a censure and cease-and-desist order, Araiz, Further Lane and Osprey Group agreed to pay disgorgement and prejudgment interest totaling $347,122. Araiz also agreed to pay a $150,000 penalty and be suspended from the industry for one year.
Araiz, Further Lane and Osprey had no comment, a spokesman said.
PRE-SIGNED PROBLEMS
According to the SECs order against GW & Wade, the firm was subject to the custody rule in part due to its practice of using presigned letters of authorization and then transferring client funds without always obtaining contemporaneous client signatures. In addition, the firm did not use proper safeguards as a custodian of client funds, and failed to identify itself as a custodian to its independent auditors or in public disclosures, the SEC said.
GW & Wade also was charged with making 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.
As a fiduciary, we are tasked with upholding the highest ethical and legal standards, Neil Goldberg, a principal at GW & Wade, told Financial Planning. The SEC identified some areas we needed to address and weve taken steps [to do that] in four specific areas.
The firm has hired Beth Lehman, whose background includes working as enforcement counsel for the SEC, as chief compliance officer and general counsel. GW & Wade also implemented new procedures around letters of authorization as well as now requiring telephone confirmations of wire requests by clients, Goldberg said. In addition, GW & Wade has put in enhanced controls around implementing advisory fees to clients and access to client accounts such as checking accounts and 401(k) accounts held outside its custodian, National Financial Services, according to Goldberg.
Responding to a request for comment from Focus, a spokesman said: Impacted clients have been made whole, and the settlement requires that GW & Wade enhance their compliance practices.
QUARTERLY STATEMENTS MISSING
According to the SECs order against Knelman Asset Management and its CEO and chief compliance officer Irving Knelman, the firm had custody of the assets of a fund of private equity funds named Rancho Partners I. However, Ranchos funds were not subject to annual surprise examinations and Rancho members did not receive quarterly account statements from a qualified custodian.
Additionally, Ranchos financial statements were not audited or distributed to Rancho members, the SEC said. Its 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, the firm 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. Knelman Asset Management and Knelman also consented to compliance training and other compliance-based undertakings. Knelman did not respond to a request for comment.
CUSTODY RULES
The majority of investment advisors do not maintain custody of client assets, which are instead held by qualified third-party custodians such as a bank or broker-dealer, the SEC noted in a statement.
Investment 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 SEC said. The commission amended the custody rule in 2010 to strengthen investor protections by requiring all advisers 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 investors at least quarterly. Advisors with custody of hedge fund or other private fund assets may alternatively comply with the custody rule through fund audits by an auditor registered with the Public Company Accounting Oversight Board, 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.
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