I know you’ve been eagerly awaiting the return of SEC CustodyFest. Let’s turn to the second matter brought by the SEC on October 28th: Further Lane Asset Management. This case actually did not revolve around the investment adviser custody rule; other issues were at play as well.
But the custody issue started ten years ago. In September 2003, following an OCIE exam, the staff issued a deficiency letter to Further Lane. The letter advised the registered investment adviser that if it was deemed to have custody of a client’s assets and securities and did not comply with the provisions outlined in certain no-action letters, it would be subject to all of the requirements of Advisers Act Section 206(4) and the custody rule, including the requirement to undergo an annual surprise examination by an independent public accountant. (Until 2010, an investment adviser with custody of a client’s assets could avoid the surprise exam requirement if it took other steps.)
Later, Further Lane did in fact maintain custody of hedge fund clients’ assets, but Further Lane and its CEO Joseph Michael Araiz failed to arrange for an annual surprise examination to verify the funds’ assets or for fund investors to receive account statements at least quarterly from the funds’ qualified custodian. Both omissions are plain violations of the custody rule after 2010.
Further Lane and Araiz had some disclosure issues with its investors as well. In 2008 and after, the two advised the Windmill Fund Multi Strategy Fund, LP, a $2 million fund-of-funds. As a result of an in-kind redemption of a Windmill Fund investment in an underlying fund, the Fund acquired a $772,000 promissory note from an entity owned by Araiz. Windmill’s governing documents, Araiz, and Further Lane all neglected to tell investors that Windmill might acquire related party promissory notes or otherwise deviate from its fund-of-funds investment strategy. Windmill later invested in a second promissory note (with a non-affiliated entity) without written disclosure to investors.
Araiz and Further Lane cooperated extensively with the SEC staff, but along with an affiliated broker-dealer, still managed to rack up almost $500,000 in disgorgement and civil penalties. Araiz was also suspended from the securities industry for a year.
Note to investment advisers: Pay attention to the annual surprise exam requirement and the requirement to be sure your clients are getting quarterly account statements from your qualified custodians. Also, protip: Don’t name your company in a way that can be abbreviated “FLAM”. If something goes wrong, it’s too tempting for the SEC not to say it that way in their administrative orders.