Adviser Violated Custody Rule by Pooling Assets Pending Investment
The SEC has commenced enforcement proceedings against the principals of a now-dissolved investment advisory firm for violating the custody rule by pooling investor funds for investment into a third party hedge fund. According to the SEC, the adviser instructed all clients to wire funds to the same Florida bank account and then wired the pooled funds to the underlying offshore hedge fund in the name of one affiliated entity. Such pooling resulted in the adviser gaining custody of the client assets, but the clients never received the required statements from a qualified custodian, and the adviser never engaged a surprise audit. The SEC also charges that the adviser collected undisclosed referral fees and accepted unearned investment management fees because it invested all client funds in one group of underlying hedge funds. The SEC has charged the principals, rather than the adviser, because the adviser is no longer operating.
OUR TAKE: Any type of client asset pooling pending investment into will trigger the custody rule’s requirements to deliver statements and obtain a surprise audit. Fund-of-funds providers should examine their current practices to make sure that they don’t inadvertently violate the Rule.