Adviser and SEC Settle Custody Charges Over Dual Employee Arrangement
Advisory firms that share employees with third parties need to be certain that the practical realities of these arrangements do not create Custody Rule violations and/or conflicts of interest. One adviser recently found out the hard way what happens when the SEC raises questions.
Wisconsin-based advisory firm Financial Fiduciaries and its founder, Thomas Batterman, on March 5 settled charges with the agency that the firm violated Rule 206(4)-2, the Custody Rule, and engaged in conflicts of interest. Both of these allegations revolved around an employee jointly compensated by the adviser’s sole member, a company called WTC that manages the adviser’s payroll, and a Colorado-based third-party trust company that served as a trustee for certain of Financial Fiduciaries’ clients’ trusts.
"From early 2012 to mid-2015, Financial Fiduciaries . . . failed to disclose to certain of its clients financial conflicts of interest created by [its] arrangement with [the] third party trust company," the SEC said in its administrative order instituting the settlement. "Because of these arrangements and the fact that an employee of Financial Fiduciaries’ parent company handled funds of [the advisory firm’s] clients, from early 2012 to mid-2014, Financial Fiduciaries had custody over some of its clients’ assets while failing to implement sufficient controls designed to protect those client assets from loss or misappropriation."
"It is very easy to get the application of the Custody Rule wrong and run afoul of the SEC," said Faegre Baker Daniels partner Jeffrey Blumberg. "The SEC’s somewhat recent guidance about inadvertent custody (ACA Insight, 11/13/17) reinforces this priority and this settlement illustrates how a registered investment adviser can end up having custody without intending to."
"Even though it appears that there was not client loss or harm, the SEC found that the adviser did not take required action to safeguard client assets over which it has control in violation of the Advisers Act," said Tesser Ryan partner Gregory Ryan.
"The settlement seems to serve as a reminder/warning to investment advisors that they must be aware of the authority of all direct and indirect persons, including persons who may be considered dual employees of the adviser and another entity," he said. "The adviser must look not only at job titles and positions, but must scrutinize the authority and conduct of all persons who may have control over client assets."
"In particular, you should be careful when your employees wear more than one hat," said Shearman & Sterling partner Jay Baris. He also noted that the Custody Rule has some "pitfalls that may not be readily apparent." For example, he said, an adviser is deemed to have custody of client assets when it has the power to access an account.
In a statement, Financial Fiduciaries said that the "the matter did not in any way involve Financial Fiduciaries’ two main lines of business – private wealth management and financial planning for individuals and surplus management for insurance companies. There was no finding of any impropriety with the firm’s client assets or discretionary accounts or even that any such assets were not fully accounted for."
WTC in December 2011 and Investors Independent Trust Company (IITC) entered into an agreement under which IITC would hire Financial Fiduciaries to provide investment advisory services for the trust company’s clients in Wisconsin, according to the administrative order. Among other things, IITC agreed to:
Act as a custodian for the trust assets of Financial Fiduciaries’ clients who used IITC as a trustee;
Maintain a trust services office in WTC’s and Financial Fiduciaries’ offices in Wausau, Wisconsin;
Be the exclusive provider of investment advisory services for all IITC clients requiring such services;
Have one WTC employee in Wausau serve as a "dual employee" of IITC and TWC;
Pay WTC $2,000 per month as part of the dual employee’s compensation;
Pay WTC "variable monthly rent" – which the SEC said amounted to about $3,000 per month – for office space and other office support for the IITC Wisconsin office equal to 50 percent of the total monthly administrative, custody and base account fees (after reduction for expenses) earned by IITC from Financial Fiduciaries’ clients.
The dual employee and client funds
The dual employee, who the SEC did not name, served in that role from January 2012 through mid-June 2014, when she retired, according to the agency. She performed primarily bookkeeping work for WTC. For IITC, she performed trust administrative services for the trust company’s Wausau clients. These duties included serving as the primary liaison with IITC, helping to set up new client accounts and updating account information, assisting with deposits and distributions of trust funds, distributing client correspondence, and court and tax return reporting.
"From early 2012 through mid-2014, the WTC ‘dual employee’ had direct access to and control over assets of Financial Fiduciaries’ trust clients by virtue of her also being an employee of IITC," the SEC said. "Pursuant to a September 4, 2012 IITC corporate resolution, she was authorized to act on behalf of IITC, to include opening/closing client accounts, purchasing and selling securities in the accounts, and transferring funds into and out of such accounts.
In addition, the agency said, the dual employee "had direct check writing authority over an IITC account at a local bank in Wausau. She received and deposited checks into the account from trust clients of Financial Fiduciaries, and wrote checks out of the account to trust beneficiaries." The dual employee, the SEC said, "reported to Batterman, who knew of and approved . . . the arrangement."
Custody Rule requirements and violations
Rule 206(4)-2 requires that advisers with custody of client assets put a set of procedural safeguards in place to prevent loss, misuse or misappropriation. Direct or indirect possession of client funds or securities, or any authority to obtain possession of those assets, counts as custody. An adviser also has custody if a related person has possession of client funds or securities or has the authority to obtain possession of them.
Under the Rule, an investment adviser who has such custody must ensure that the assets are maintained by a qualified custodian, meaning entities such as a federally ensured bank or savings association, a registered broker-dealer, a registered futures commission merchant, or a foreign financial institution. The adviser must ensure that a qualified custodian maintains the client funds in a separate account for each client under the client’s name or in accounts that contain only the clients’ funds and securities under the adviser’s name; notify each client in writing of the qualified custodian’s name, address and how the funds are maintained; have a reasonable basis for believing that the qualified custodian sends account statements to each client at least quarterly, and have an independent public accountant perform a surprise examination of the clients’ funds and securities at least once each year.
What the SEC alleged is that Financial Fiduciaries stated in its Form ADV in 2012, 2013 and 2014 that it did not have custody of client assets, when it actually did have custody from 2012 through mid-June 2014, the agency said. "The ‘dual employee’ of WTC and IITC had direct access to certain Financial Fiduciaries’ clients’ trust assets as an authorized signatory on an IITC local bank account in Wausau," the agency said. "She received and deposited checks into the account from trust clients of Financial Fiduciaries, and wrote checks out of the account to trust beneficiaries."
Further, according to the administrative order, the advisory firm failed to take a number of actions, including:
Notify clients that it maintained custody of client assets;
Maintain client funds in a separate account for each client under that client’s name, or in accounts that contain only the client’s funds under Financial Fiduciaries’ name as the agent or trustee for the client; or
Have an independent public accountant perform a surprise exam of the client’s trust assets over which the advisory firm had access.
Conflict of interest and fiduciary breach
Financial Fiduciaries did not disclose, prior to August 2015, on its Forms ADV or otherwise to clients "the material conflicts of interest that existed as a result of the fee and employment arrangements between WTC and IITC," the SEC said. Batterman, the agency said, "had ultimate authority" over the content of Financial Fiduciaries’ Forms ADV.
Given the financial arrangements between the advisory firm and IITC, "Financial Fiduciaries had financial incentives to recommend to clients that they designate IITC as a successor trustee for their trusts, leading to conflicts of interest," the SEC said.
Violations and punishment
As part of the settlement, the agency alleged that Financial Fiduciaries willfully violated Section 206(2) of the Advisers Act, which prohibits fraud; Section 206(4) and its Rule 206(4)-2, the Custody Rule; and Section 207, which prohibits the making of untrue statements of material fact in any registration application or report filed with the Commission. The settlement stated that Batterman caused these alleged advisory firm violations.
Financial Fiduciaries was ordered to pay a civil money penalty of $40,000, while Batterman was ordered to pay a civil money penalty of $20,000.
The SEC noted that this was not Batterman’s first brush with the Custody Rule, stating that in 1997, he settled a separate agency action "based primarily on custody violations and misrepresentations to clients regarding brokerage rates by an investment adviser formerly registered with the Commission."