In this last chapter of SEC CustodyFest, we visit Knelman Asset Management Group. For this case, I’m mostly interested in discussing a change to the SEC’s custody rule, Rule 206(4)-2, from 2010.
Before its amendment in March of that year, the rule required advisers with custody of its clients’ assets to:
have a reasonable basis for believing that a qualified custodian was sending quarterly account statements to its clients, or
send the quarterly account statements itself and obtain an annual surprise examination by an independent public accountant to verify all of the client assets.
The amended rule generally requires these advisers to do both. They must have a reasonable basis for believing that a qualified custodian is sending quarterly statements to clients and be subject to an annual surprise examination. Both the pre-and post-amendment Rule 206(4)-2(b) have provided exceptions for an adviser of a pooled investment vehicle from the quarterly account statement and surprise examination requirements if certain criteria are met. These include an annual audit of the pool by a PCAOB-registered CPA and yearly audited financial statements prepared in accordance with GAAP.
Knelman Asset Management
As its managing member, Knelman had custody of the assets of Rancho Partners I, LLC, a private fund of funds. As with the other participants in SEC CustodyFest, Knelman had two primary custody failures, but others as well. From 2000 through 2011, Rancho members did not receive quarterly account statements from a qualified custodian, and Rancho’s funds were not subject to an annual surprise examination. Rancho’s assets also were not maintained by a qualified custodian, and its financial statements were not audited or distributed to Rancho members.
In 2005, the SEC’s staff notified Knelman that it had failed to comply with the custody rule. The letter further said that because Rancho members did not receive account statements directly from a qualified custodian, and Rancho’s financial statements were not audited, Knelman had violated the custody rule. Finally, the letter said Knelman had also violated the rule because it held a stock certificate owned by Rancho in a safe deposit box that was not a qualified custodian. The firm fixed the stock certificate issue but, unwisely, did not address its other custody rule deficiencies.
In 2010, after Knelman re-registered with the Commission, the staff conducted another exam and learned that the firm still had custody of Rancho’s assets. The staff also learned that Knelman was violating the custody rule because it did not have a reasonable basis for believing that a qualified custodian was sending quarterly statements to Rancho members and it had not arranged for annual surprise exams of Rancho’s assets. Alternatively, Knelman had not arranged for Rancho’s financial statements to be audited annually and distributed to Rancho’s members.
Knelman and its CEO Irving Knelman were ordered to cease and desist from committing or causing any violations of Sections 204, 206(2), 206(4) and 207 of the Advisers Act and Rules 204-2(b)(1), 204-2(b)(2), 204(2)(c)(2), 206(4)-2, 206(4)-7, and 206(4)-8. They had to pay a total of $130,000 in civil money penalties, and Irving Knelman was barred from acting as the chief compliance officer of an investment adviser or broker-dealer.
Lessons for Investment Advisers
SEC CustodyFest attendees: Hasn’t it been fun? Also: do you see a pattern here? The SEC really cares about the custody rule, in particular the surprise exam and quarterly account statement requirements. Given the limited staff it has to examine investment advisers, it can’t afford to ignore the rule or to avoid enforcement action when it sees substantial violations. You have numerous ways to comply. Get with it and fix your weak spots before the SEC fixes them for you.