Readers of this space – and SEC observers generally – will recall a March 4 risk alert designed to warn investors about the ways U.S. investment advisers had recently been found to have violated the SEC’s asset custody rule. The number and variety of violations were legion. Advisers were not assuring themselves that clients were receiving quarterly account statements. They weren’t subjecting themselves to surprise examinations designed to assure compliance with the rule. The list went on, and the Commission’s Office of Compliance Inspections and Examinations closed with a polite reminder that “[a]dvisers may want to consider their policies and procedures and their compliance with the custody rule in light of the deficiencies noted in this Alert.”
Apparently the memo came a bit too late for Vector Wealth Management. On April 18th, the SEC brought a settled enforcement action against the Minnesota-based investment advisor for alleged violations of the custody rule and for failing to properly supervise an employee who misappropriated client funds.
According to the administrative order, Vector discovered that one of its clerical employees, Charles Fee, misappropriated $33,147 of dividends owed to four clients over a period of about 2½ years. A Vector principal had check-signing authority over particular investment pools but had delegated to the clerical employee the responsibility to prepare distribution checks. Fee allegedly wrote checks to himself and – somehow . . . Jedi mind trick? – had the principal sign them. Vector learned about the scheme while trying to reconcile an unrelated, potentially erroneous payment, and then quickly self-reported Fee’s conduct to the SEC’s staff. The Commission charged Fee separately with violations of Section 10(b) of the Exchange Act.
Unfortunately, Vector had not prepared itself for such a scenario. Before discovering the scheme, Vector had failed to adopt or implement procedures reasonably designed to prevent violations of the custody rule. Specifically, the adviser had not ensured that investors in its pooled vehicles were receiving quarterly account statements or audited financial statements on an annual basis. Vector also failed to conduct an annual compliance review of its advisory activities.
Rule 206(4)-2 generally provides that it is “fraudulent, deceptive, or manipulative” for any registered investment adviser to have custody of client funds or securities unless, among other things, the adviser has a reasonable basis for believing that a qualified custodian is sending quarterly account statements to each of the clients for which it maintained funds or securities. The rule is designed to protect advisory clients from the misuse or misappropriation of their funds and securities. Vector failed to send any quarterly statements related to the investment pools at issue during the relevant period.
The rule also required Vector to undergo a surprise examination by an independent public accountant at least once a year, but Vector failed to do so for the investments pools at issue.
Finally, Vector’s alleged failure to adopt policies and procedures reasonably designed to prevent violations of the custody rule violated Rule 206(4)-7.
Failure to Supervise
Section 203(e)(6) of the Advisers Act authorizes the Commission to impose sanctions on an investment adviser if it “has failed reasonably to supervise” those subject to its supervision. Here, Vector allegedly failed to reasonably supervise its employee Charles Fee in a manner that would have prevented his misappropriation scheme.
For this string of violations, the SEC censured Vector and imposed a rigorous compliance regime, including the appointment of an independent compliance consultant and reporting obligations.
Several lessons arise from this case. First, advisers have to keep a close watch on all of their client assets. This was not a huge amount of money, and Vector notified its clients of the scheme and repaid them with interest. But the SEC cares very much about custody rule breakdowns like this, and will punish violators and their supervisors. Second, advisers have to be aware of the conduct of their investment adviser representatives and their clerical employees, especially if they have access to client funds. Advisers should consider whether their routine procedures for check writing and other instances where money could leave the building are sufficiently rigorous. If a firm’s principal cannot figure out that checks are being written directly to lower-level staff, think about whether checks should be double-signed by firm management. Finally, Vector avoided a civil penalty here based on its cooperation, but the independent compliance consultant will not be much fun to pay for. Investment advisers should get a handle on their custody rule obligations or they will pay, one way or the other.