On October 29, 2014, the Securities and Exchange Commission (“SEC”) announced an administrative enforcement action against an investment advisory firm and three top officials for violating rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”), the “custody rule,” that requires firms to follow certain procedures when they control or have (or are deemed to have) access to client money or securities. This enforcement action follows closely on the heels of statements by SEC officials indicating that violations of the custody rule were a recurring theme during the “presence exams” of private equity fund advisers and other first time investment adviser registrants that have been conducted by the SEC staff over the last year and a half.
Advisory firms with custody of private fund assets can comply with the custody rule by distributing audited financial statements to fund investors within 120 days of the end of the fiscal year. This provides investors with regular independent verification of their assets as a safeguard against misuse or theft. The SEC’s Enforcement Division alleges that Sands Brothers Asset Management LLC has been repeatedly late in providing investors with audited financial statements of its private funds, and the firm’s co-founders along with its chief compliance officer and chief operating officer were responsible for the firm’s failures to comply with the custody rule. As investment adviser registrants are painfully aware, chief compliance officers have personal liability for compliance failures under Advisers Act rule 206(4)-7. This particular enforcement action was brought pursuant to section 203(f) of and rule 206(4)-2 under the Advisers Act. It remains to be seen whether the SEC will bring a separate action against the Sands Brothers’ chief compliance officer under rule 206(4)-7.
Also nervously awaiting any further action by the SEC would be the accountants and lawyers that advised the Sands Brothers and their hedge funds with respect to the custody matter. The accounting firm or firms that conducted the audit of the Sands Brothers hedge funds likely knew that the funds did not meet the requirements of the custody rule. It is less certain whether the external lawyers knew or should have known about these violations. However, if either the accountants or lawyers knew of these violations and advised that they were only technical in nature and immaterial or unimportant, the SEC could take separate administrative action pursuant to SEC rule 102(e) to bar any such party from practicing before the SEC. We previously wrote about the more aggressive posture that the SEC signaled with respect to service providers, specifically lawyers that assist or “aid and abet” violations of the securities laws. The SEC has a fairly high standard to meet when bringing these types of cases, but that has not deterred the regulator from aggressively pursuing more accountants and lawyers in recent months.
According to the SEC’s order instituting the administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010. The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late. The same materials for fiscal year 2012 were distributed to investors approximately three months late. According to the SEC’s order, Sands Brothers and the two co-founders were previously sanctioned by the SEC in 2010 for custody rule violations.