Published on:

The SEC Warns Investors Of Deficiencies In Investment Adviser’s Compliance With Custody Rules

On March 4, 2013, the Securities and Exchange Commission (“SEC”) issued an investor alert regarding the custody rule under the Investment Advisers Act of 1940, Rule 206(4)-2, and its importance in safeguarding investors’ funds from misuse or misappropriation by their investment advisers. The custody rule outlines the requirements for how a SEC registered investment adviser must maintain custody of client accounts and securities in order to ensure that the investment advisers do not engage in fraud, deceptive, or manipulative acts, when holding their clients’ assets. Although most investment advisers engage third-party custodians to hold their clients’ assets, the firms that do not utilize a third-party custodian, and instead maintain custody of their clients’ assets, create increased concerns for the SEC, as there is a larger chance the investment adviser could engage in fraud. For example, the $65 billion Ponzi scheme perpetrated by Bernard L. Madoff was partially attributed to the fact that Madoff’s firm maintained custody of his clients’ assets, rather than holding the clients’ assets at a third-party custodian. In light of these concerns, the SEC’s National Examination Program (“NEP”) conducted an examination of investment advisers’ compliance with the custody rule and found widespread non-compliance in over 140 advisory firms.

As a result of these findings, the SEC issued the investor alert to educate investors and remind investment advisers about the importance of the custody rule. The NEP grouped the non-compliance into the following four categories: (1) failure by an adviser to recognize that it has “custody” as defined under the custody rule; (2) failure to comply with the rule’s “surprise exam” requirement; (3) failure to comply with the “qualified custodian” requirements; (4) and failure to comply with the audit approach for pooled investment vehicles. Some specific examples of advisers failing to recognize that they maintain control of their clients’ assets include: (1) adviser’s personnel serving as trustee or power of attorney for clients’ accounts; (2) advisers providing bill paying services for clients and having authorization to make withdrawals of funds or securities from clients’ accounts; and (3) advisers comingling client, employee and proprietary assets. In the investor alert, the SEC reminded investment advisers that deficiencies and violations may result in the examiner referring the incident to the SEC Department of Enforcement and subsequent litigation. The SEC Chairman Elise Walter made the following statement: “Because the safeguarding of assets is central to investor protection, it is crucial that investment advisers follow our rules when they maintain custody of their clients’ funds.” Additionally, Carlo di Floio, director of the SEC’s Office of Compliance Inspections and Examinations, stated, “we take deficiencies in this area very seriously and want to put advisers on alert about the importance of complying with the custody rule. It is a key component of our investment adviser examination program.”

Lax & Neville LLP effectively assists investors, on both a regional and national level, that may have suffered losses as a result of their investment advisers’ sales practice abuses. Please contact our team of securities fraud attorneys for a consultation at (212) 696-1999.

Contact Information