Former Compliance Officer No Longer Expected to Settle
On October 29, 2014, the SEC announced that it had instituted administrative proceedings under the Investment Advisers Act of 1940 against Sands Brothers Asset Management LLC (Sands Brothers), its two co-founders and the individual who served as both CCO and COO. The action addresses alleged repeated violations of the so-called “custody rule” arising from failure to timely deliver to investors audited financial statements of private funds managed by Sands Brothers. This proceeding is ongoing.
The Custody Rule
Section 206(4) of the Investment Advisers Act of 1940, as amended (Advisers Act), and Rule 206(4)-2 thereunder (Custody Rule), contain certain requirements that apply where a registered investment adviser has “custody” of client funds or securities. For this purpose, the general partner and management company of a private fund (i.e., the client) are considered to have custody of the fund’s cash and securities, and therefore must comply with the Custody Rule if registered (or required to register) as investment advisers with the SEC.
Among other things, the Custody Rule requires that registered investment advisers having custody of client funds and securities maintain these assets with a “qualified custodian.” Additionally, the manager of a private fund or other pooled investment vehicle intending to comply with the Custody Rule through the so-called “audit exemption” provided under Rule 206(4)-2(b)(4) must deliver annual GAAP-audited financial statements of the fund to all of its investors within 120 days (or 180 days for a fund-of-funds) after the end of the fund’s fiscal year and upon liquidation of the fund. This recent SEC proceeding against Sands Brothers demonstrates that the SEC takes the mandated time periods of the audit exemption very seriously.
OCIE’s 2013 Custody Rule Risk Alert
In March 2013, the Office of Compliance Inspections and Examinations (OCIE) of the SEC issued a Risk Alert entitled “Significant Deficiencies Involving Adviser Custody and Safety of Client Assets.” This Risk Alert dealt with the Custody Rule generally and noted that the SEC’s National Examination Program (NEP) had observed “widespread and varied” non-compliance with elements of the Custody Rule.
In this Risk Alert, OCIE signaled an intense focus on the Custody Rule (“one of the most critical rules”), clearly cautioning registered advisers to strictly comply with all applicable elements. Additionally, OCIE specifically described a number of different compliance failures by advisers that had been relying on the Custody Rule’s audit exemption, including these advisers’ failure to send GAAP-audited financial statements of the fund to investors within the mandated time frame. The Risk Alert also noted that NEP made referrals to the SEC’s Division of Enforcement where appropriate. Click here for access to this Risk Alert.
The Sands Brothers 2010 Consent Order
This is not the first time Sands Brothers has been cited for Custody Rule issues. In 2010, the SEC entered into a consent order involving Sands Brothers, Steven Sands and Martin Sands (the 2010 Consent Order). That action also alleged Custody Rule deficiencies, including the failure to distribute audited statements within the Custody Rule’s mandated time frame.
The 2010 Consent Order provided:
- for censure of Sands Brothers and its two co-founders;
- that Sands Brothers must pay a $60,000 civil penalty; and
- that Sands Brothers and its two co-founders would cease and desist from committing or causing violations, or future violations of, among other things, the Custody Rule.
Click here for access to the 2010 Consent Order.
The 2014 SEC Proceeding Against Sands Brothers
The 2014 SEC Order alleges that Sands Brothers failed to timely deliver audited financials to investors across 10 private funds in respect of fiscal years 2010, 2011 and 2012. According to the SEC, Sands Brothers was at least 40 days late for fiscal year 2010, over six months late for fiscal year 2011 and approximately three months late for fiscal year 2012.
The SEC noted that “the circumstances that led the audits to be delayed were predictable” and that Sands Brothers, its two co-founders and its CCO all failed to make “adequate efforts” to ensure that Sands Brothers met its Custody Rule obligations. The SEC stated that, in effect, Sands Brothers and its management continued the same behavior that originally led to the 2010 Consent Order. In the opinion of the SEC, Sands Brothers management simply ignored its own undertakings made in the 2010 Consent Order.
Click here for access to the 2014 SEC Order.
The Chief Compliance Officer
In a May 2014 speech, SEC Director of Enforcement Andrew Ceresny outlined the circumstances in which the SEC will seek sanctions against compliance personnel. Ceresny emphasized that the SEC would take action against compliance officers if they had clear responsibility to implement compliance programs and “wholly” failed to carry out that responsibility. Click here for access to our legal alert on this May 2014 speech.
The 2014 SEC Order names the CCO of Sands Brothers as a respondent. The 2014 SEC Order alleges the following:
- While the CCO was not a party to the 2010 Consent Order, he nevertheless was involved in, and aware of, the 2010 Consent Order; he even notarized the offer of settlement to enter into the 2010 Consent Order on behalf of Sands Brothers;
- The CCO was responsible for compliance with the Custody Rule as reflected in the firm’s compliance manual;
- The CCO knew that the audits were not being distributed on time; and
- The CCO “wholly” failed to implement any policies or procedures to ensure compliance with the Custody Rule even after the 2010 Consent Order or after Sands Brothers continued to miss the Custody Rule’s delivery deadline year after year. As stated in the 2014 SEC Order, “at most, he simply reminded people of the Custody Rule deadline without taking any more substantial action.”
Notably, the Form ADV of Sands Brothers currently on file with the SEC lists a different individual as being CCO of Sands Brothers.
The 2014 SEC Order does not involve a situation where the SEC is seeking sanctions against a person whose sole function is that of chief compliance officer. In this case, the individual who served as the CCO also served as the firm’s chief operating officer. The 2014 SEC Order points out that, in the view of the SEC, he was responsible for all operational functions, other than investment decisions.
On December 1, 2014, the 2014 proceeding was stayed as to the former CCO because the SEC’s Division of Enforcement and the CCO had reached an agreement in principle on settlement. Click here for access to the December 1, 2014, order.
On December 24, 2014, the stay was lifted in an order which states that the former CCO would not proceed with the settlement. Click here for access to the December 24, 2014, order.
The SEC is Seeking Serious Sanctions
Given the 2010 Consent Order, the alleged continuing and preventable Custody Rule violations, and the apparent absence of settlement in this latest proceeding by Sands Brothers, its two founders and the former CCO/COO, the SEC appears intent on seeking more severe penalties this time around.
Indeed, the 2014 SEC Order makes it clear that the SEC’s Division of Enforcement may seek, among other things:
- suspension or revocation of the registration of Sands Brothers as an investment adviser; and
- an industry bar in the case of the individual respondents.
“The Custody Rule is not a technicality.”
These were the words of Andrew M. Calamari, director of the SEC’s New York regional office, as quoted in the SEC’s press release announcing the 2014 SEC Order. Registered investment advisers should take note that the SEC views each applicable element of the Custody Rule as a “critical investor protection provision.”
Fix problems and Fulfill Promises.
In Calamari’s words, “Sands Brothers and its senior-most officers have persistently disregarded their obligations under the law.” It is very clear that Sands Brothers’ alleged continued failure to comply with the specific mandates of the Custody Rule was a significant problem, particularly in light of the 2010 Consent Order and OCIE’s explicit guidance in its 2013 Risk Alert.
Be Proactive and Diligent.
It is not enough for compliance personnel to sit back and wait for problems to present themselves. In the words of the SEC, it is also not enough for compliance personnel to have “simply reminded” violators of the rules “without taking any substantive action” to affirmatively address the problems.
Compliance personnel must be proactive in monitoring for, and addressing, the unique compliance risks posed by the structure, business and operations of the firm and its personnel under the firm’s compliance policies and applicable securities laws and regulations. Additionally, compliance personnel must be diligent in carrying out and, to the appropriate extent, documenting execution of the functions assigned to them in their firm’s compliance policies.