Audit Firm Censured/Fined for Negligent Surprise Custody Exams
An audit firm and its engagement partner were censured and fined for negligence in performing surprise exams under the custody rule. Rule 206(4)-2 requires an adviser to engage an audit firm to perform a surprise exam to verify client funds and securities where the adviser maintains custody. The SEC charged that the audit firm should have known from documents and information readily available and received that the adviser commingled client securities with its own in a single bank account that collateralized a loan to the adviser. The SEC alleged that the bank account was in the name of the adviser and not designated for the benefit of its clients. The SEC also charged the firm for failing to conduct surprise examinations because it gave prior notice of the exam or allowed the adviser to select the date. The SEC charged the engagement partner with failing to properly supervise the exam because he devoted only 1.5 hours per year to the exam.
OUR TAKE: The SEC will hold third party service firms accountable for a client’s unlawful activities especially where they have specific regulatory responsibilities. The Custody Rule relies on legitimate surprise exams to verify client assets.