On September 5, 2023, the SEC announced charges against five Registered Investment Advisers (RIAs) that failed to comply with requirements designed to safeguard clients’ assets. Three of the firms were also charged with failing to update their disclosure of audits of their private fund clients’ financial statements. The five RIAs agreed to settle the SEC’s charges and to pay more than $500,000 in combined penalties.
In these cases, a related person of the RIA served as the managing member or general partner of their private funds during the relevant time periods and had the authority to make decisions for, and act on behalf of, them. Therefore, the RIA had custody of the funds’ assets as defined in the Custody Rule.
In a press release, the SEC stressed the importance of the Custody Rule and Form ADV reporting obligations. According to Andrew Dean, Co-Chief of the SEC Enforcement Division Asset Management Unit, “The Custody Rule and the associated Form ADV reporting obligations are core to investor protection.” Dean added, “We will continue to ensure that private fund advisers meet their obligations to secure client assets.”
The five firms failed to do one or more of the following:
- Have audits performed;
- Deliver audited financials to investors in a timely manner; and/or
- Ensure that a qualified custodian maintained client assets.
According to the SEC’s orders, two of the RIAs failed to promptly file amended Forms ADV to reflect they had received audited financial statements. One of the RIAs failed during multiple years to properly describe the status of its financial statement audits when filing the firm’s Form ADV.
Although they did not admit or deny the findings, the RIAs agreed to be censured and to cease and desist from future violations. They also agreed to pay civil penalties ranging from $50,000 to $225,000.
Background information on the Custody Rule
Pursuant to the Custody Rule, RIAs with custody of clients’ funds or securities must satisfy certain compliance requirements to prevent the loss, misuse, or misappropriation of those assets. An RIA is deemed to have custody if it holds – directly or indirectly – clients’ funds or securities or the adviser has the authority to obtain possession of those assets.
Among other requirements, an RIA with custody of clients’ 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 is sending account statements at least quarterly to clients. (However, 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 clients’ 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 RIA.
The Custody Rule provides an alternative compliance approach for investment advisers to limited partnerships, limited liability companies, or other types of pooled investment vehicles. The Custody Rule states that an investment adviser to private funds must be subject to an audit at least annually. Furthermore, the adviser must distribute the audited financial statements to all limited partners within 120 days of the fund’s fiscal year end. The audited financial statements must be prepared in accordance with Generally Accepted Accounting Principles (GAAP). The accountant performing the audit must be an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB).
What these five private fund advisers did wrong
It is helpful to take a quick look at the five enforcement actions. The first case involved an RIA with its principal place of business in Austin, Texas. The SEC’s complaint charged the RIA with failing to maintain securities of certain private equity funds that it advised with a qualified custodian. Furthermore, in some instances, the private fund adviser failed to conduct or timely distribute annual audited financial statements that were prepared in accordance with GAAP to investors in certain private funds that it advised. In addition, the RIA did not update certain responses in its Form ADV as is required by the instructions.
The second action was brought against another investment adviser to private funds based in Wayne, Pennsylvania. The SEC alleged that the RIA failed to have the required audits performed. The firm did not timely distribute annual audited financial statements prepared in accordance with GAAP to investors in a private fund that it advised. In addition, the RIA did not properly describe the status of its fund’s financial statement audits when filing the firm’s Forms ADV. The RIA also did not update certain responses in its Form ADV annual updating amendments for multiple years.
The third RIA charged, which is based in Bedford, New Hampshire, is also an investment adviser to private funds. The RIA failed to maintain securities of certain private funds that it advised with a qualified custodian. Furthermore, the RIA failed to conduct and timely distribute annual audited financial statements prepared in accordance with GAAP to investors in certain private funds that it advised.
The SEC charged a fourth investment adviser to private funds, based in Hong Kong, with failing to distribute annual audited financial statements to investors in a timely manner. Certain audits were completed pursuant to the International Standards on Auditing, which did not satisfy the rule, and the auditor was not registered with the PCAOB. These failures resulted in violations of the Custody Rule.
The fifth enforcement case involved another investment adviser to private funds. The RIA, based in Yardley, Pennsylvania, was charged with failing to timely distribute annual audited financial statements prepared in accordance with GAAP to investors in certain private funds that it advised. In addition, the RIA did not update the firm’s Forms ADV promptly as those audits occurred.
This is not the first time that the SEC has sanctioned private fund advisers for violating the Custody Rule and Form ADV requirements. On September 9, 2022, the SEC charged nine advisory firms with violations related to the Custody Rule and their Form ADV obligations. The enforcement actions are available HERE.
Based upon this many enforcement actions in less than a year, it is clear that SEC examiners will be scrutinizing private investment advisers’ compliance with the Custody Rule. Private fund advisers must also properly describe the status of their financial statement audits when filing their Form ADV. Enforcement actions send a loud and clear message to RIAs that examiners will be on the lookout for certain compliance violations that pose a threat to investors.
The SEC’s press release, as well as the five enforcement actions, can be reviewed HERE.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.