SEC Charges Three Firms with Violating Custody Rule (with Lofchie Comment)

The SEC sanctioned three SEC-registered investment advisory firms for violating the "custody rule" which requires each firm to meet certain standards when maintaining custody of their clients' funds or securities.

In 2010, the SEC amended the custody rule to strengthen investor protections. The amendment required all advisers with custody to undergo an annual "surprise exam" to verify the existence of client assets.

Advisers are required to comply with the custody rule if, as elaborated in the SEC releases linked to below, the investment adviser has "legal ownership or access to client assets or an arrangement permitting them to withdraw client assets." The majority of investment advisers do not maintain custody of client assets, preferring instead to have assets held by a qualified third-party custodian such as a bank or broker-dealer.

Advisers with custody of hedge fund or other private fund assets may alternatively comply with the custody rule through fund audits by a PCAOB-registered auditor, provided that financial statements are delivered to investors.

SEC investigations found that the three sanctioned firms failed to maintain client assets with a qualified custodian or engage an independent public accountant to conduct surprise exams.

Lofchie Comment: The SEC has signaled in every possible way that compliance with the custody rule is a high priority (as it should be). Firms should take this as another warning to conduct a self-examination as to their custody procedures.

See: SEC Order for Further Lane Asset Management; SEC Order for GW & Wade; SEC Order for Knelman Asset Management Group.
See also: SEC Press Release.
See generally: Guide to Hedge Fund Regulation: Ownership and Custody Chapter.