Imagine being Andrew Bowden. As director of the SEC’s Office of Compliance, Inspections and Examinations, you know you don’t have enough staff to conduct reasonably regular exams of registered investment advisers. You also know that some members of Congress continue to take great delight in beating up the SEC for its failures with the Bernard Madoff scandal. If a similar scheme escaped the SEC’s notice for a long time, the consequences for the agency could be disastrous.
If you were Bowden, or any senior staff member at the Commission, you might want to have some rules to back you up, to ensure that while you’re not watching, things at investment advisers do not fall too far off track. As it happens, the investment adviser custody rule is just such a rule. Briefly, the rule prescribes a number of requirements designed to enhance the safety of client assets by insulating them from possible unlawful activities or an investment adviser’s insolvency. Among other things, it requires advisers to maintain client funds at a “qualified custodian,” such as a bank or broker-dealer, to undergo an annual surprise examination by an independent public accountant that verifies client funds and securities, and to be reasonably sure that the qualified custodian is sending account statements at least quarterly. The SEC takes this rule very seriously. Seriously enough to issue a risk alert in March that highlighted a vast array of custody rule violations identified in over 140 examinations of investment advisers. And seriously enough to bring follow-up enforcement actions when the violations are sufficiently drastic.
That’s what the SEC did on October 28th, when it announced three settled administrative actions against investment advisers that, among other things, had committed violations of the custody rule. We’ll cover these three matters over three posts this week and next.
In the first, Wellesley, Massachusetts-based adviser GW & Wade, LLC presented an issue that is common to many custody rule situations: exactly when does an adviser have custody, anyway? According to the rule, “[c]ustody includes. . . any capacity. . . that gives you or your supervised person. . . access to client funds or securities.” Rule 206(4)-2(d)(2)(iii). In one type of client arrangement, GW & Wade maintained blank Letters of Authorization (“LOAs”) that the firm filled out on its own when necessary to transfer client funds. This practice enabled the firm to transfer client funds without having to obtain client signatures in every instance. GW & Wade investment advisory representatives on occasion also cut out the signature from a previously executed LOA and pasted it onto a new LOA to effect authorized transfers of client funds. The arrangement certainly gave the firm “access” to, and thereby custody of, its clients’ assets under the rule.
Here, the practice also ultimately contributed to a third-party fraud in June 2012 when an individual hacked into a client’s email account and, posing as the client, sent emails to GW & Wade requesting that the client’s funds be wired to a foreign bank. Three separate overseas wires later, totaling $290,000, the fraud was discovered. GW &Wade compensated the client for all losses associated with these unauthorized wires.
But in running its business this way, GW & Wade allegedly did not do two critical things. With respect to these client arrangements giving rise to custody, the firm failed to obtain an examination by an independent public accountant and to identify the assets of which it had custody in its public filings. As a result, these assets were not subject to surprise audits, and GW & Wade’s disclosures regarding custody in its Forms ADV were allegedly inaccurate.
GW & Wade also allegedly committed other books-and-records violations. The firm did offer prompt cooperation to the SEC’s staff and agreed to implement policies that would prevent similar violations from happening in the future. In addition to paying a $250,000 civil penalty, GW & Wade is required to retain an independent consultant to conduct a comprehensive review of the firm’s written compliance policies and procedures. We’ll cover the other two cases at SEC CustodyFest over the next week or so.