United States: A Compilation Of Non-Enforcement Actions

Non-Enforcement Matters

SEC Revises Its Custody Rule

The SEC's Custody Rule (Rule 206(4)-2) was recently revised by the SEC* to target the abuses cited in the Madoff Ponzi scheme and other frauds.

The revisions to the Custody Rule (Rule), which are summarized below and effective March 12, 2010, will affect a significant number of registered investment advisers (RIAs), including those who manage private funds. Although the Rule is directly applicable only to those investment advisers registered with the SEC under the Investment Advisers Act of 1940, investment advisers registered under state securities laws also will be subject to these requirements, as many of the state securities laws require a state-registered investment adviser to comply with the SEC's Rule.

The Rule governs the RIA's custody of client funds and securities. The Rule applies if the RIA holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. Accordingly, having custody includes the obvious and not so obvious situations. An RIA will have custody for, among other things, if the RIA maintains the client's checkbook, if it has the authority to deduct its fees directly from the client's account, if it is the general partner or manager of a private fund in which it has legal ownership or access to the fund's cash or securities, if it or one of its associated persons is a trustee for a client's account, or if an affiliate has custody of client assets. The SEC staff has historically applied an expansive interpretation of when an RIA, directly or indirectly, has custody of client funds or securities.

The Rule requires that the client funds or securities be held by a "Qualified Custodian" (which term includes a bank or registered broker-dealer). The Rule requires the RIA to have reasonable belief that the Qualified Custodian has sent account statements, on at least a quarterly basis, to the clients. The option under the prior Rule for the RIA to send clients the required account statements instead of the Qualified Custodian is no longer available. The reasonable belief requirement can be met by having the RIA receive a copy of the client account statements that were sent by the Qualified Custodian. The SEC has determined that the reasonable belief requirement could not be met by the RIA merely confirming that the account statements were on the Qualified Custodian's Web site. The RIA is required to notify its clients in writing if the client's funds and securities are maintained at a Qualified Custodian and changes in such arrangement. In addition, if the RIA also sends out statements to clients (billing statements, for example), it is required to remind clients on at least an annual basis to compare the RIA's statements with those received by the client from the Qualified Custodian.

The revised Rule requires RIAs that have custody of client funds or securities to have a "surprise examination" conducted during each calendar year by an independent accountant registered and supervised by the Public Company Accounting Oversight Board (PCAOB). The purpose of the surprise examination is to verify that client funds and securities under the custody of the RIA are held by a Qualified Custodian in the manner required under the Rule.

The surprise examination is not required under certain limited exceptions (such as when the RIA's only custody of client funds or securities is tied to its authority to deduct its fees directly from the client's account, or if the Qualified Custodian that is the RIA or is a related person of the RIA can be shown to be "operational independent" of the RIA, or if the RIA provides advice to "a private fund" when an audit of the financial statements of the fund is provided to each fund investor within 120 days of the fund's fiscal year-end). Within 120 days following the surprise examination, the accountant is required to file Form ADV-E with the SEC that serves to report the results of the accountant's examination. Immediate notice is required to be filed with the SEC if the accountant finds any "material discrepancies" during the examination, and notice within four business days of its resignation or dismissal from the engagement and for certain other listed events.

For an RIA that serves as the Qualified Custodian or utilizes a related person to be the Qualified Custodian, an additional requirement is imposed. In such cases, the RIA is required to obtain from the related Qualified Custody, at least annually, an internal control report prepared by an independent accountant registered and supervised by the PCAOB with respect to the Qualified Custodian's internal controls. The required report is commonly referred to as a Type II SAS 70 report. An examination of internal controls conducted in accordance with AT Section 601, Compliance Attestation under the standards of the American Institute of Certified Public Accountants (AICPA) would be a suitable substitute for the Type II SAS 70 report.

The SEC in its companion release to the revised Rule provides guidance to independent accountants with respect to both the surprise examination and internal control report examination requirements.* The SEC also has adopted amendments to Form ADV that are intended to provide more information about the RIA's custody and its practices.

For those RIAs who provide investment advisory services to a private fund, the Rule's requirements are met if the fund's financial statements are audited by a PCAOB-registered accountant, a copy of the statements are provided to each of the fund's investors within 120 days after the fund's fiscal year-end, and a final audit of the fund is conducted when the fund is liquidated at a time other than the end of its fiscal year.

All RIAs with custody will need to review and revise their written policies and procedures to ensure that they are reasonably designed to prevent violations of the revised Rule.

RIAs are expected to be in compliance with the revised Rule by March 12, 2010. For those RIAs subject to the surprise examination requirement due to the revised Rule, they must enter into a written agreement with a PCAOB-registered and supervised accountant to conduct the first examination by no later than December 31, 2010. For those RIAs subject to the internal control report requirement, the surprise examination need not be conducted until six months after the RIA receives the internal control report. The first internal control report must be received by the RIA by no later than September 12, 2010.

RIAs who rely on the private fund audit exception to the surprise examination requirement must enter into a written agreement with an independent PCAOB-registered and supervised accountant to conduct the first audit of the fund for the fiscal year beginning on or after January 1, 2010. Amendments to Form ADV with respect to items pertaining to the applicable provisions of the Rule are required to be filed in the RIA's annual amendment filed after January 1, 2011.

Mutual Fund Investors Fail in Efforts to Prove Excessive Fees Were Charged
The U.S. District Court for the Central District of California (In Re American Mutual Funds Fee Litigation, C.D. Cal. Case No. CV 04-5593, 12/28/09) recently ruled for the defendants against the plaintiff, mutual fund investors, with respect to claims that American Funds violated the provisions of Section 36(b) of the Investment Company Act of 1940 by imposing excessive fees. The Court applied the standards in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2nd Cir. 1982), which concluded that a violation of Section 36(b) arises from an advisory fee that is "so disproportionately large that is bears no reasonable relationship to the services rendered and could not be the product of arm's-length bargaining." The Court commented that "this standard establishes a very low threshold of the registered mutual fund company and a very high hurdle for a plaintiff."

The question of what is an excessive fee for purposes of Section 36(b) of the Investment Company Act of 1940 is currently being considered by the U.S. Supreme Court in Jones v. Harris Associates L.P., U.S. No. 08-586. In that case, a divided U.S. Court of Appeals for the Seventh Circuit rejected the Gartenberg standard ruling that marketplace competition should govern.

In this case, the plaintiffs were investors in one or more of eight American Funds. The investment adviser to the funds received management fees, an affiliate broker-dealer received distribution and marketing fees, and the funds also received 12b-1 fees from investors that were paid out as a method of compensating broker-dealer distributors and for providing certain other administrative services to investors.

In effect, the Court determined that the plaintiffs failed to prove that all of the fees received by the investment adviser and its related parties "were so disproportionate to the services rendered such that the fees could not have been the product of arms-length bargaining." Accordingly, the Court ruled that plaintiffs did not meet the Gartenberg standard.

SEC Announced Efforts to Deter and Detect Madoff-Type Frauds
In response to severe criticism from investors and politicians, the SEC has undertaken steps to help reduce the chances that frauds such as the Madoff Ponzi scheme will not occur or go undetected in the future. Those steps include:

Restructuring of the SEC's Enforcement Division: With the appointment of a new Enforcement Director, the SEC has restructured this division to better focus on cases that are likely to have a significant impact. This restructuring is intended to help reduce bureaucracy and speed up the enforcement process by removing a layer of management. Specialized units will be included to concentrate in focused areas and help detect patterns, trends, and motives. Finally, streamlined internal processes will be implemented to make the investigative process more efficient.

Encouraging Insiders' Cooperation: The SEC is working on agreements to encourage the cooperation of individuals who are on the "inside" of companies engaged in fraudulent activity. These agreements will purportedly provide that insiders who offer truthful evidence and agree to cooperate and testify would be eligible for a possible reduction in sanctions. Such agreements would be expected to provide the SEC with witnesses and key information in enabling the agency to build stronger cases more quickly.

Conducting Risk-Based Examinations of Financial Firms: The SEC has instructed its examiners to conduct a "sweep" of certain firms to determine that the clients' assets in fact exist. Such firms include advisers whose clients' assets are held with an affiliate; hedge funds that seem to have unrealistic returns; firms that use an unknown auditor or no auditor at all; firms with a regulatory history; and broker-dealers that sell an affiliate's hedge fund.

Recruiting Staff With Enhanced Experience in Detecting Fraud: The SEC is in the process of expanding its staff to include persons with diverse skill sets to expand its knowledgebase and improve its ability to assess risk, conduct examinations, detect and investigate wrongdoing, and focus the SEC's priorities. The specialized personnel will include new staffers for the examination unit who have experience in trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting, and those with expertise in current financial products and techniques.

Improving Internal Controls: Both the SEC's examination unit and Enforcement Division has implemented a periodic review program to help ensure that important issues are thoroughly resolved in a timely manner and that no investigation falls through the cracks.

Seeking More Funding: The SEC has been asking Congress for additional funding to hire more examiners to conduct on-site examinations and more enforcement staff to bring more enforcement cases.

Integrating Broker-Dealer and Investment Adviser Examinations: The SEC has instituted certain measures to integrate its broker-dealer and investment adviser examination programs. It is expected that a team of examiners, taken from both the broker-dealer and investment management units, will together examine selected firms.

*See SEC Release no. IA-2968 for a copy of the revised Custody Rule and commentary on same; the release can be found on the SEC Web site at http://www.sec.gov/rules/final/2009/ia-2968.pdf.

*See SEC Release No. IA-2968 for interpretative guidance for independent accountants, available at http://www.sec.gov/rules/interp/2009/ia-2969.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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