RIA Compliance Blog
Custody presents a compliance danger for investment advisers, including advisers to private funds. Three recent enforcement cases illustrate the importance of diligent compliance for fund advisers with custody of client assets.
According to the Advisers Act, an investment adviser has custody of client assets if it holds, directly or indirectly, client funds or securities, or if it has the authority to obtain possession of those assets. See Advisers Act Rule 206(4)-2(d)(2).
The custody rule of the Advisers Act deems it a “fraudulent, deceptive, or manipulative act, practice, or course of business” for an investment adviser to have custody of client funds unless the adviser observes the following “Safekeeping Requirements”: (1) ensure that a qualified custodian maintains the client assets; (2) notify the client in writing of custodian accounts the adviser opens on the client’s behalf; (3) reasonably believe that the custodian sends account statements at least quarterly to clients; and (4) engage an independent public accountant to audit the adviser each year at a time chosen by the accountant without prior notice or announcement to the adviser. See Advisers Act Rule 206(4)-2(a)(1)-(5).
Safekeeping Requirement (4) is known as the “surprise audit” requirement as it subjects advisers to be audited without warning at times unknown to the advisers. The Rule makes an exception to the surprise audit requirement for investment advisers to pooled investment vehicles such as private funds. Those advisers “shall be deemed to have complied with” the surprise audit requirement with respect to a fund if the fund is subject to audit at least annually and “distributes [the fund’s] audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners… within 120 days of the end of [the fund’s] fiscal year.” See Advisers Act Rule 206(4)-2(b)(4). The auditing accountant must be an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”). See Advisers Act Rule 206(4)-2(b)(4)(ii).
An applicable investment adviser that fails to meet the Audited Financials Alternative’s requirements would need to satisfy all requirements of Rule 206(4)-2(a)(2)-(4) to avoid violating the custody rule. Ultimately, these rules unite to mean that an investment adviser with custody of client assets will be found liable for fraud, deceit, or manipulation unless it provides audited financials to its clients within 120 days of the fiscal year’s end.
Additionally, an investment adviser that has “custody of the funds and securities solely as a consequence of [its] authority to make withdrawals from client accounts to pay [its] advisory fee” is exempt from Safekeeping Requirement (4). This means that investment advisers whose only authority to add or subtract client funds is to pay their own fees avoid the requirement of undergoing any surprise audits or the Audited Financials Alternative.
Finally, Rule 206(4)-7 also requires SEC registered advisers to adopt and implement written policies and procedures “reasonably designed to prevent violation of the Advisers Act and rules thereunder.” This creates a duty for advisers with custody of client assets to adopt, implement, and update guidelines for compliance with all custody requirements.
In the case of Cedar Legacy, LLC, Cedar Legacy was an investment adviser with multiple funds that settled with the SEC without admitting or denying the SEC’s claims. According to the SEC, despite stating in its Forms ADV that two of its funds relied on the Audited Financials Alternative to comply with the custody rule, Cedar Legacy failed to complete the funds’ 2020 and 2021 audits and issue the reports until April 30, 2023. This meant that the 2020 audit reports were 730 days late and the 2021 audit reports were 365 days late. The SEC also found that Cedar Legacy failed to adopt and implement written policies and procedures to prevent violation of the Advisers Acts or its promulgated rules. In their settlement, the SEC censured Cedar Legacy and charged a civil money penalty of $75,000.
In a similar case, ClearPath Capital Partners LLC, a registered investment adviser, settled with the SEC without admitting or denying its findings. The Commission found that, from 2018 through 2022, ClearPath reported reliance on the Audited Financials Alternative but failed to distribute audit reports to fund clients within 120 days of fiscal year end. In 2018, one fund was never audited. The following year, the same fund was audited, but no reports were issued to clients. For another fund, these reports were issued 333 to 1,064 days after the fiscal year-end. The SEC also found that ClearPath failed to adopt and implement written policies and procedures to prevent violation of the Advisers Acts or its promulgated rules. The Order agreed to by both parties included a censure by the SEC of ClearPath and $65,000 in civil money penalty.
In the third case, Nebari Partners, LLC is a registered investment adviser that agreed to a settlement without admission of the SEC’s findings. The Commission found that Nebari reported reliance on the Audited Financials Alternative for 2021 and 2022 but never conducted the requisite audit of its Special Purpose Vehicles and issued no audit report. The SEC found this to be a violation of the custody rule, and Nebari paid $80,000 to settle the claim.
These rules, exceptions, and cases all illustrate the tightrope an investment adviser with custody of client assets must walk. As always, it’s best to consult experienced attorneys before taking custody of client assets.
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 compliance with federal and state laws and rules. Please visit our website for more information.