Last month, the Securities and Exchange Commission (“SEC”) brought and simultaneously settled administrative proceedings against accounting firm Santos, Postal & Co. P.C. (“SPC”) and one of its accountants, finding that SPC and the accountant conducted deficient surprise audits of investment adviser SFX Financial Advisory Management Enterprises (“SFX”). The surprise examinations were conducted pursuant to the SEC custody rule and are designed to confirm the adviser’s appropriate handling of assets under their custody and to uncover, to the extent possible, fraudulent activity of the advisers.
As background to this enforcement action, under Advisers Act Rule 206(4)-2, investment advisers with custody of client funds or securities must maintain certain controls, commonly known as “safekeeping procedures,” to protect those assets. State-registered advisers must comply with rules that vary from state to state, but the model rule of the North American Securities Administrators Association is substantially similar to the SEC rule. Since approximately March 2010, the Rule has required advisers that have custody other than because of an ability to deduct client fees to obtain an annual surprise exam by an independent public accountant to verify all client assets. Another basic requirement of the rule applicable to all advisers with custody is having a reasonable basis for believing that a qualified custodian or the adviser sends quarterly account statements to each client for which custody was maintained. Advisers that advise hedge funds or pooled investment vehicles may satisfy the audit requirement and other safekeeping provision by having an audit completed by a PCOAB auditing firm and timely delivering audit results to the fund’s shareholders.
The SEC’s order alleges that SPC and its accountant partner engaged in repeated failures, including filing erroneous reports that contained untrue statements regarding the examinations they conducted. More specifically, the SEC alleged that SPC submitted three reports on Form ADV-E in which SPC stated that it had examined the adviser’s assertion that it was in compliance with Rules 204-2(b) and 206(4)-2 of the Investment Adviser’s Act. At least one of the reports falsely stated that SPC had confirmed with SFX’s clients certain contributions to and withdrawals from the client’s accounts when, in fact, SPC had not confirmed those matters. The order also alleges that SPC failed to exercise due care required of accounting professionals, failed to exhibit the professional skepticism required by the standards for certified public accountants, and failed to truthfully fulfill the compliance attestations required of accounting firms that conduct custody examinations for SEC registered advisers.
According to the SEC, there were significant risks that should have been identified by a competent accounting firm. Among these were that at least two individuals had full signatory powers over client bank accounts relating to bill payment services that SFX provided to its clients. Another risk factor was there was an inadequate segregation of duties within the bill paying process, which, according to the SEC order, created a significant risk of misappropriation.
The SEC’s order also found that the accounting firm did not receive and evaluate an adequate sampling of data and that the items selected for sampling were not representative of the population of transactions by the adviser.
The order found that SPC and the accountant willfully violated Section 207 of the Adviser’s Act, which makes it unlawful for a person to make an untrue statement of material fact in any report filed with the SEC. The order revoked the accountant’s privilege of appearing or practicing before the SEC and ordered the both the accountant and SPC each to pay a $15,000 civil penalty, and ordered SPC to disgorge its profits gained as a result of the examination in the amount of $25,800.00.
Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.