Custody Rule Violations - Deliberate and Inadvertent

On October 29, 2014, the SEC charged a registered investment adviser, its two principals and the chief compliance officer with repeated violations of the Custody Rule (Rule 206(4)-2 under the Advisers Act). The advisory firm managed a number of pooled investment vehicles and failed to distribute audited financial statements to investors within the 120-day window from fiscal-year end as mandated by the Custody Rule.

The firm failed to deliver timely audited financials for three consecutive years. Specifically, in 2010, the firm delivered financial statements for ten private funds forty days late. In 2011, it delivered audited financials for the same funds with a six- to eight-month delay, and in 2012 with a three-month delay. The case was brought as an administrative proceeding. In the Matter of Sands Brothers Asset Management, LLC, Adm. Proc. File No. 3-16223 (October 29, 2014).

The firm and its two principals and co-founders, Steven and Martin Sands, appear to be recidivists. In 2010, the firm was charged with several Custody Rule violations and settled an SEC administrative proceeding in which the firm was ordered to cease and desist from violating the custody rule, censured and required to pay a $60,000 penalty. The Custody Rule violations in that proceeding noted late delivery of financial statements, financials that were not in accordance with GAAP and several misstatements on the firm’s Form ADV including a statement that the adviser did not have custody of client assets when, in fact, it did. The adviser had custody of the assets held by the private funds it managed by virtue of its relationship with the funds as general partner or managing member.

The securities law violations by the firm and the principals were not limited to violations of the Custody Rule. The firm had also been sanctioned in the past by the Connecticut Department of Banking for violations of the state’s securities laws. The two principals were also broker dealer representatives. Among other violations, Steven Sands had his broker-dealer registration subjected to a number of conditions by the State of Connecticut and his license suspended by the NASD. Martin Sands had twice been temporarily barred from association or suspended from holding supervisory positions, censured and fined by the NYSE, and had restrictions imposed on his broker-dealer registration and his investment adviser agent registration by the State of Connecticut.

Last week’s enforcement action charged Steven and Martin Sands with aiding and abetting the Custody Rule violations since they were responsible for ensuring that compliance personnel had the authority to implement procedures and policies as necessary to ensure that the adviser complied with the Advisers Act. As for the Chief Compliance Officer, he was charged with aiding and abetting as well because he was tasked in the compliance manual with ensuring compliance with the restrictions and requirements of the Custody Rule and he knew that the audited financial statements were not being distributed on time. It appears at most that he reminded people of the time deadline, but failed to take any substantial action to remedy the violations.

It is interesting to see what kind of penalties the court will impose given the serial recidivist behavior of the investment adviser and its top executives. The enforcement action can be found here.

Our Perspective

Although the violations alleged in this enforcement action are egregious, the case also serves as a useful reminder that the SEC continues to focus on compliance with the Custody Rule by registered investment advisers.

In our experience, advisers often breach the Custody Rule inadvertently and not intentionally, simply because they are not familiar with many of the technical aspects of the Custody Rule. First, they sometimes fail to recognize their custody requirements arising from acting as general partner or managing member of a fund they advise.

In addition, some inadvertent violations of advisers to private funds are failures to comply with the “audit exception” and include:

  • Making audited financial statements available to investors upon request instead of actually delivering those financials to all investors within the 120-day window;
  • Delivering audited financial statements electronically without consent to electronic delivery;
  • Delivering audited financial statements which are not prepared in accordance with GAAP;
  • Winding down a fund without a final liquidation audit; and
  • Using an auditor that is not both PCAOB and subject to inspection--both requirements need to be met to comply with the Custody Rule and one should not assume that all PCAOB-registered firms are being inspected. In particular, some auditors located outside the US may not be subject to inspection.
  • The auditor fails to file a Form ADV-E and the surprise examination report electronically on IARD.

The SEC has periodically issued guidance about the Custody Rule, including the following:

Because many private fund managers rely on the audit exception provision, they should review their policies, and procedures to ensure compliance with the Custody Rule.

We advise that advisers include a review of compliance with the Custody Rule as part of their annual review to determine if any changes are necessary, either because of new regulatory guidance or because of changes in their business.

SEC3 can assist with any questions or concerns you may have, or if you wish to implement any changes to your policies and procedures.


Get the latest compliance news and insights - delivered weekly. The SEC3 Communique covers all compliance topics. CCO3 focuses on CCO topics.
tip: check both to keep informed!


Overlooked Benefits of E&O/D&O

While asset managers should always be aware of the protections provided by their E&O/ D&O coverage, there are more reasons than ever to think about it now. The SEC continues to... read more »

SEC3 Newsletter

Commentary: How Compliance Officers & Firms Can Help Limit CCO Personal Liability This article originally appeared on the Thomson Reuters Regulatory Intelligence subscription service for compliance and risk professionals and is... read more »

Wishing One-and-All a Happy, Healthy and Prosperous New Year

We hope each of you found some peace and tranquility in the company of loved ones this holiday season and want to wish one-and-all a happy, healthy and prosperous New... read more »

Understanding How to Mitigate Liability and Navigate Insurance Options (Part II)

In June, we shared our thoughts around common insurance gaps and insurance riders that CCOs as well as managers should understand. One of the gaps we shared related to pre-claim... read more »

Cybersecurity - What have we learned and what have we done?

Regulatory Landscape In April 2015, the Securities and Exchange Commission ("SEC's") Division of Investment Management issued a guidance update, identifying cybersecurity as a critical issue. Several regulators are in fact focusing... read more »

Gatekeepers in SEC Crosshairs

Ever since the enforcement cases were announced as part of the SEC’s “Operation Broken Gate,” the SEC enforcement division has continued to ramp up scrutiny of gatekeepers including third-party service... read more »


Upcoming Events - September & October 2017

Upcoming Events Don’t miss the opportunity to meet with us in person to discuss the topics that matter most to you. SEC3 is teaming up with industry experts in NYC to discuss...

May 23, 2017 - Webcast: WannaCry Ransomware: Were You Really Protected or Just L…

When: Tuesday, May 23rd, 2017 | Schedule: 12pm - 1pm EST Who: Paul Caiazzo, CEO and Co-Founder, TruShield Security Solutions Michael Brice, Founder, BW Cyber Services John Lukan, Managing Director, SEC Compliance Consultants, Inc. We...

June 14, 2017 - Compliance Breakfast Briefing

8:30-9:00am - Networking and Continental Breakfast 9:00-10:30am - Program Location: Willkie Farr & Gallagher LLP | 600 Travis Street | Suite 2310 | Houston, TX Barry Barbash from Willkie Farr & Gallagher LLP,...

June 13, 2017 - Compliance Breakfast Briefing

8:30-9:00am - Networking and Continental Breakfast 9:00-10:30am - Program Location: Haynes and Boone, LLP | 2323 Victory Avenue | Suite 700 | Dallas, TX 75219 Validated parking is available in the garage attached...

May 31, 2017 - Chicago

9:00-9:30 a.m - Networking and Continental Breakfast 9:30-11:00 a.m - Program Location: Baker & McKenzie LLP | 300 East Randolph Drive | Suite 5000 | Chicago, IL 60601 Kristin Gonzalez and Jerome Tomas...

May 17, 2017 (NYC WIMF)

This event is by invitation only. Please email to learn more.

May 15, 2017 (NYC Chief Compliance Officer Roundtable)

9:00-9:30am - Networking and Continental Breakfast 9:30-11:00am - Program Location: Blank Rome LLP | The Chrysler Building | 405 Lexington Avenue | New York, NY 10174 | 22nd Floor Boardroom | Phone:...

Webcast: The Most Insidious Cybersecurity Threat Is Also The Least Understood

When: Tuesday, April 25th | Schedule: 12pm - 1pm EST Who: Paul Caiazzo, CEO and Co-Founder, TruShield Security Solutions Michael Brice, Founder, BW Cyber Services John Lukan, Managing Director, SEC Compliance Consultants, Inc. Ransomware, the...

CCO Liability (Part III): Managing Liability Webinar

In this webinar, panelists discuss indemnifications and insurance as potential remedies to address the direct financial risks to a CCO. Attendees will learn: What terms and conditions should Chief Compliance Officers be...

Webinar: CCO Liability (Part III): Managing Liability: Navigating Indemnities an…

When: Tuesday, February 21, 2017 Schedule: 11:00am ET / 10:00am CT / 9:00am MT / 8:00am PT / 7:00am AT Description of Webinar: The National Society of Compliance Professionals is pleased to host...

Webcast: SEC 2017 Examination Focus Area – Cybersecurity Testing

Penetration Testing & Vulnerability Assessments - Examining the SEC & FINRA Requirements When: Wednesday, January 25th | Schedule: 12pm - 1pm EST Who: Paul Caiazzo, CEO and Co-Founder, TruShield Security Solutions Michael Brice, Founder,...

Chief Compliance Officer Roundtable: Breakfast Briefing

When: October 20, 2016 Where: Blank Rome LLP | The Chrysler Building | 405 Lexington Avenue | New York, NY 10174 | 22nd Floor Boardroom | Phone: 212.885.5000 Thomas Westle and Janaya...

Practicing Law Institute - Hedge Fund Management 2016

When: September 15, 2016 Where: New York & concurrent webcast | 1177 Avenue of the Americas | New York, NY 10036 Schedule: 9:00 am – 5:00 pm Janaya Moscony, President of SEC3 will...


When: April 13, 2016 Where: Blank Rome LLP | The Chrysler Building | 405 Lexington Avenue | New York, NY 10174 22nd Floor Boardroom Thomas Westle and Janaya Moscony, along with industry experts,...


When: November 17, 2015 Where: Convene Midtown East | 730 Third Avenue | New York, NY 10017 Janaya Moscony, President, SEC Compliance Consultants, Inc. will be moderating a...