Two Strikes: Adviser in Custody Case Faces Harsher Penalties the Second Time Around
Five years ago, the SEC settled with an adviser by charging the firm $60,000. Last month, when the agency settled with the adviser again in regard to similar violations, the SEC was a bit harsher: It raised the fine to $1 million, required the retention of a compliance monitor, set daily penalties for future failures to comply, and suspended the firm from the industry for a year.
The SEC doesn’t like "recidivists," its term for repeat offenders, and will often step up penalties when it finds them.
New York City-based adviser Sands Brothers Asset Management and its co-founders, Steven and Martin Sands, along with its chief compliance officer, reached their second settlement with the SEC on November 19 on charges of being repeatedly late in providing investors with audited financial statements of the adviser’s private funds. That’s a violation of Rule 206(4)-2, the Custody Rule.
Perhaps worse, at least from the SEC’s point of view, the adviser violated the rule without regard to an October 2010 order requiring the firm to cease and desist from the same type of activity, according to the agency.
The CCO, who the agency said aided, abetted and caused the firm’s Custody Rule violations by failing to implement procedures and safeguards, reached a separate settlement with the SEC on the same day. He was ordered to pay a $60,000 fine and was barred from serving as a CCO in the securities industry for one year.
"There is no place for recidivism in the securities markets," said SEC New York Regional Office director Andrew Calamari. "The Sands brothers missed their opportunity to right a previous wrong and instead merely repeated their Custody Rule violations, so they face more severe consequences."
"The message from this case is that if the SEC tells you there is a problem, you’d better fix it," said Latham & Watkins partner Nabil Sabki. "If you receive a comment letter from the SEC, you need to make sure the same problems don’t exist when examiners re-visit."
Sands Brothers "consented to an SEC order in the first settlement that included a requirement that it comply with the Advisers Act Custody Rule, and it then, according to the SEC, knowingly proceeded not to comply with the rule," said McDermott Will & Emery partner Ted Laurenson. If that’s true, he said, the firm was "operating in contempt of the SEC. If you’ve been slapped back once, you really need to make sure that it doesn’t happen again – especially deliberately."
"There were no allegations of fraud, misrepresentation or misappropriation," said the attorney representing the firm and the two brothers, adding that his clients were pleased to have the matter behind them. "This case was about the timing of when otherwise accurate audits were distributed."
The Custody Rule
Rule 206(4)-2 requires that advisers with custody of client assets establish procedural safeguards to prevent loss, misuse or theft of those assets. An adviser is considered to have custody if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those assets.
If an adviser has custody, it must meet a series of requirements, including ensuring that client funds and securities are verified by an annual examination conducted by an independent accountant. Alternatively, advisers of pooled investment vehicles may distribute audited financial statements, audited by an independent public accountant, to all shareholders within 120 days of the vehicle’s fiscal year end.
Yesterday and today
Sands Brothers’ history with the SEC on this matter goes back to 1999, when the SEC’s Office of Compliance Inspections and Examinations conducted a review of the adviser. The examiners found that Sands Brothers "wrongly stated in its Form ADV that it does not have custody of client assets," when in the view of the examiners, it did. The deficiency letter sent by the agency also spelled out some of the requirements the firm had to meet when deemed to have custody under the Advisers Act.
Subsequent examinations of the firm in 2004 and 2009, as well as an investigation by the Division of Enforcement, led to the SEC’s 2010 settlement with Sands Brothers. The order instituting that settlement said that the firm failed to either submit to an adequate audit or to timely distribute audited financial statements. It also found that the firm continued to state that it did not have custody over client assets. As a result, the firm, Steven Sands and Martin Sands were censured and required to pay a civil money penalty of $60,000.
Unfortunately, if the SEC is to be believed, that did not result in a change of behavior.
"The 2010 order notwithstanding, [Sands Brothers] failed to comply with the Custody Rule in the years that followed," the agency said. "[The firm] neither submitted to a surprise examination, nor distributed its audited financials in the 120-day window imposed by the rule. Indeed, [Sands Brothers] took no remedial action in response to the 2010 order to implement policies and procedures aimed at ensuring compliance with the Custody Rule."
From 2010 through 2012, Sands Brothers was deemed to have custody of client assets, the SEC said, and distributed its funds’ audited financial statements for those fiscal years after the 120-day deadline had passed. In 2010, the agency said, the audited financial statements were at least 40 days late; in 2011, at least six months late; and in 2012, approximately three months late.
The circumstances that led to these delays were "predictable and not unforeseeable," the agency said. The auditors "had repeated difficulty obtaining the information they needed to value the same portfolio companies year over year … even though for some of those companies, S. Sands and/or M. Sands served on the company’s board, and for one such portfolio company, [the chief compliance officer] acted as president and chief executive officer."
Violations and penalties
Sands Brothers was charged by the SEC with having willfully violated Section 206(4) of the Adviser Act and its Rule 206(4)-2 for failing to take steps required to safeguard client assets over which it had custody. In addition, Steven Sands and Martin Sands were charged with having willfully aided and abetted, as well as caused, the firm’s violations of the Custody Rule.
Among the requirements the new settlement placed on Sands Brothers was the retention of an independent monitor, beginning within 30 days of the order and continuing for three years. The monitor will perform annual compliance reviews of the firm, with the firm required to adopt all of the monitor’s recommendations.
The settlement specifically requires the firm to provide the monitor with "satisfactory evidence of delivery of audited financial statements to investors" or "satisfactory evidence of completion of surprise examination." If Sands Brothers opts to provide audited financial statements to investors and then fails to comply, it will be required to pay $15,000 per fund for each day it fails to provide the monitor with satisfactory evidence that it provided audited financial statements to investors on time.
In addition, the firm, Steven Sands and Martin Sands were suspended from acting as an investment adviser to any new clients, or raising money or assets on behalf of their funds, for a year.
Finally, the three respondents were collectively required to pay a civil money penalty of $1 million.
The message from the SEC: Meet your settlement obligations. It will be a lot tougher the second time around.