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News August 24, 2015 Issue

Advisers May Retain Custody After Selling Their Firms

An advisory firm owner who sells his firm but maintains multiple overlapping responsibilities with the funds he created may still have custody of the client assets in those funds.

That appears to be the takeaway from an August 6 SEC administrative order against an advisory firm owner who sold his individual-client business but, according to the agency, used a different structure to continue to do business. The new structure  involved operating the firm as an "integrated investment adviser" through overlapping functions with the managing members of the pooled investment vehicles that were among the firm’s clients, the SEC said. The agency’s order institutes an administrative proceeding against the owner.

The Commission’s position is that the advisory firm’s new structure did not remove the obligations of its owner, Reid Johnson, to meet Advisers Act Rule 206(4)-2, the Custody Rule. Specifically, the SEC alleged that Johnson’s firm, The Planning Group of Scottsdale (TPGS), from 2010 to 2012, failed to accurately determine the securities over which it had custody, failed to ensure the securities were maintained by a qualified custodian, and failed to obtain adequate surprise examinations, according to the order instituting administrative and cease-and-desist proceedings.

"The key to this SEC complaint is where the SEC argues that the adviser and the managing members of the funds were all the same entity," said Stern Tannenbaum partner Aegis Frumento. "If they were separate entities, then the adviser would have had no custody of assets and the Custody Rule was not violated; if they were the same entity, then the adviser did have custody and the Custody Rule was clearly violated, based on the SEC’s description."

"This case confirms that the SEC views it improper for an adviser to avoid registration or other requirements by separating its functions into separate legal entities, at least where corporate formalities are not observed," said Rogers & Hardin partner Stephen Councill. "The SEC staff has been concerned about this kind of issue for awhile. Whenever there are multiple entities under common control and management, it is wise to consider whether viewing the businesses as one would change the regulatory requirements, and to assess whether corporate formalities are being appropriately observed."

The case also "highlights the need for investment advisers to hire qualified compliance personnel who keep abreast of developments in regulatory requirements," said Zacarro Morgan partner Nicolas Morgan. "Among other things, the SEC is charging that Johnson appears to have been unaware of the 2009 amendments to the Custody Rule that make annual surprise examinations mandatory for all advisers subject to the Rule. He was also allegedly unaware or simply ignored the 2009 amendment’s change to the definition of ‘custody,’ which indicates that an adviser has custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services it provides to clients."

This is not the first time Johnson has been in trouble, according to the SEC. In addition to being the founder, sole owner, president, managing director and chief compliance officer of TPGS, he was also the president and sole owner of a former registered broker-dealer, Meridian United Capital (MUC). "In October 2013, Johnson received a 45-day suspension from FINRA in connection with a private placement offering for which MUC acted as a placement agent, where he was suspended for withdrawing $300,000 from escrow before MUC had satisfied the minimum sales contingency for the offering," the agency said.


TPGS was registered with the SEC in July 2006. In June 2012, Johnson "sold the firm’s investment advisory business with respect to individual clients, but not with respect to the advisory business conducted with the managing members" of funds he founded and controlled, the agency said. The firm filed a Form ADV-W to withdraw its registration in March 2013.

TGPS and three of the managing members of the pooled investment vehicles "had significant ownership overlap, operational overlap, capitalization overlap and advisory overlap," the SEC said. "In addition TPGS and the managing members did not conduct themselves as separate entities in dealing with outside parties and failed to observe corporate formalities."

Specifically, the agency noted the following examples of overlap:

  • Ownership overlap. TPGS and the managing members were under common control, the SEC said, alleging that Johnson, in addition to owning TPGS, owned and controlled 100 percent of two of the managing members and 50 percent of the third.
  • Operational overlap. TPGS and the managing members had both overlapping management and multiple common employees, according to the agency. "In addition, TPGS and the managing members all operated out of a shared physical location … , using the same physical infrastructure and equipment, including computers and computer servers," with TPGS paying the rent for the offices.
  • Capitalization overlap. Two of the managing members transferred funds to TPGS, "where those funds were commingled with TPGS’s funds and used to pay operating expenses," the SEC said. TPGS did not reimburse the two managing members for the transferred funds. In addition, Johnson allegedly made some of TPGS’s employees his co-signatories on bank accounts belonging to two of the managing members. Other examples of alleged capitalization overlap: TPGS paid for some of one managing member’s offering expenses, paid the salaries of employees who worked for TPGS and the managing members, loaned money to another managing member’s owner to cover its operating expenses, and reclassified on its books almost $142,000 that it had "apparently loaned" to a managing member as a reduction in the amount that TPGS owed to other "related parties," the agency said.
  • Advisory overlap. "Johnson provided investment advice on behalf of both TPGS and the managing members," the SEC said. A TPGS employee served as manager of one of the managing members and, in addition to Johnson, provided investment advice. "Johnson and TPGS also advised TPGS clients to invest in the pooled investment vehicles. Almost all of the investors in the pooled investment vehicles were TPGS advisory clients," the SEC said.

Beyond these areas of overlap, the managing members and TPGS failed to conduct themselves as separate entities when dealing with outside parties, the agency claimed. TPGS email was allegedly used to conduct business for the managing members, and TPGS letterhead was allegedly used for another managing member.

Finally, the SEC noted that TPGS and the managing members "failed to observe corporate formalities. They were all under Johnson’s common control and had no separate boards of directors," it said. "In addition, there were no policies and procedures in place to keep these entities separate, or to protect investment advisory  information for one of these entities from disclosure to the others. To the contrary, all of TPGS’s employees, who also worked for the managing members, had unlimited access to servers shared by TPGS and the managing members. Johnson had access to investment information for all of these entities whenever he made an investment decision for any of them."

Given these circumstances, the SEC said, "TPGS was required to follow the requirements of the Advisers Act with respect to the pooled investment vehicles, which were its clients."

"What the SEC is trying to do in this case," Frumento said, "is what in corporate law is called ‘piercing the corporate veil,’ in other words, showing that the business units in this case – the adviser itself and the funds – are not legitimately separate entities."

"The problem is that it is not easy to pierce the corporate veil," he continued. "Duly created corporations and LLCs are presumed to be separate entities under state law. Mere overlap of ownership, control and operations won’t usually defeat that separateness – any major corporation has such overlaps among its subsidiaries, and yet those subsidiaries still have the protections of being separate entities. In many jurisdictions, there needs to be a finding of some kind of fraud being perpetrated in order to pierce the veil of one entity to make another responsible for its actions, and there is no fraud being alleged here.

"This case seems like yet another example of the tension that exists in the private equity fund world between the legal rights that exist under state law and the obligations of the Advisers Act."

Questions of custody

TPGS, through Johnson, had custody over the funds and securities of its advisory clients, the SEC concluded. This was either because he had the capacity, through his role as owner, manager or trustee, to obtain possession of the funds and securities in the account, or because, as was the case with two of the funds, he was the only person with a key to a lock box or storage facility, according to the administrative order.

Even though Johnson was TPGS’s chief compliance officer during the majority of the time from 2010 to 2012, he "did not have any formal training regarding the Custody Rule, nor did he have the familiarity with the Custody Rule that would be expected of a compliance professional," the SEC said.

Here’s how, according to the agency, TPGS violated the Custody Rule:

  • Did not accurately determine which client securities were subject to the Rule between 2010 and 2012. Specifically, TPGS failed to recognize that securities purchased by two of the funds were subject to the Custody Rule, the agency said.
  • Failed to ensure that client securities were maintained by a qualified custodian in 2010, 2011 and 2012. The SEC noted two examples, the first when paper stock certificates for certain securities purchased by one of the funds were maintained at the TPGS offices and later Johnson’s home, and the second when paper stock certificates for securities purchased by another fund were maintained in a storage facility.
  • Did not adequately obtain independent verification – also known as the surprise examination – of client assets in 2010, 2011 and 2012. An independent public accountant was not retained pursuant to an appropriate engagement letter, the SEC said. For instance, the agency alleged, the 2010 and 2011 engagement letters with one accountant omitted required language regarding the accountant’s obligation to file a certificate on Form ADV-E within 120 days of the surprise examination’s commencement, nor that it should notify the SEC within one business day of any material discrepancies found during the exam. Another engagement letter "improperly disclosed the dates that [the independent accountant] planned to commence the surprise exam."
  • The 2010 surprise examination was not conducted during that calendar year. The accounting firm was not retained until 2011 "and performed the work for the examination in 2011, not 2010," the agency said.

Compliance program and Form ADV failures

As is typically the case when the SEC charges compliance violations, it doesn’t miss the opportunity that these violations mean the adviser’s compliance program policies and procedures were lacking.

In the case, the agency found that Johnson violated Rule 206(4)-7, the Compliance Program Rule, because the firm’s compliance manual "failed to reflect the fact that the 2009 amendments [to the Custody Rule] made annual surprise examinations mandatory for all advisers subject to the Custody Rule (with some narrow exceptions)."

Johnson was also charged with making false representations on TPGS’s Forms ADV in 2010, 2011 and 2012. In its 2010 Form ADV, the SEC said, TPGS "falsely represented that it did not have custody of any of its advisory clients’ cash or bank accounts or any of its advisory clients’ securities." In its 2011 Form ADV, "TPGS falsely represented that an independent public accountant prepared an internal control report with respect to custodial services," the agency said, but "no internal control report was ever prepared." These constituted violations of Section 207 of the Advisers Act, which makes such false representations illegal.

The case now moves to an administrative hearing, which must be held within 60 days of the administrative order. An attorney representing Johnson could not be reached for comment.