SEC Keeps Gatekeepers in Its Sights with New Accounting Firm Settlement
The SEC made it known back when Mary Jo White was the agency chair that it would go after what it terms "gatekeepers" – attorneys, accountants, consultants and others – if it believes they took part in fraud. With its May 4 settlement with an accounting firm and two of the firm’s partners, chairman Jay Clayton signaled that his SEC will do the same.
In its settlement? with Wisconsin-based accounting firm Winter, Kloman, Moter & Repp, along with two of its partners, Curtis Disrud and Paul Sehmer, the agency laid down a clear marker that if accountants retained to help advisers comply with Rule 206(4)-2, the Custody Rule, themselves violate the Rule, they can expect to be charged and, if found guilty, face financial and other penalties.
WKMR and its two partners, among other charges, allegedly failed to meet Custody Rule requirements that they be independent of the advisory firm, Voit & Company, also based in Wisconsin. Voit itself was not a party to this settlement.
Specifically, according to the administrative order instituting the settlement, the accounting firm was not independent when it was engaged to perform annual audits of Voit’s funds for 2014 and 2015 because it had already prepared financial statements for the funds for those years, and because Voit already had a direct business relationship with the accounting firm. Under that relationship, a WKMR advisory firm affiliate, received a fee when it referred advisory clients to Voit.
The SEC leveled other charges against the accounting firm and its partners as well, including that it was not subject to regular inspection by the Public Company Accounting Oversight Board, something required by the Custody Rule of accounting firms that are retained to perform independent audits. Other charges listed in the settlement were that the respondents failed to engage in proper professional conduct as spelled out in Section 4C of the Exchange Act and Rule 102(e)(1)(ii) of the SEC’s Rules of practice, among them that WKMR and Disrud failed to design and implement an appropriate response to the risk of material misstatement and failed to obtain sufficient appropriate audit evidence.
Custody and gatekeepers
Voit owner and portfolio manager Todd Voit said that his firm’s "legal counsel indicated that we did not have custody, and WKMR relied on that information. Once it was determined that we did in fact have custody, the accounting firm took steps to mitigate the damage by becoming PCAOB certified and redoing the audit."
"The Custody Rule is serious business both for investment advisers and for the service providers upon which they rely," said Pasquarello Fink partner William Haddad. "Here, the investment adviser was not charged, apparently because it did not appreciate the conflicts and issues associated with having respondents prepare and audit the funds, and serve as a referral source. Investment advisers with custody should not, however, rely on ignorance of such issues. While it is certainly tempting to ‘one-stop shop’ an accounting firm as an auditor and referral source, advisers should be careful that they don’t trip over the Custody Rule and other issues by doing so."
"The takeaway for private fund managers is the importance of performing due diligence on your vendors," said Morgan Lewis consultant attorney Steven Hansen. "Even when the advisory firm involved is not charged, this type of proceeding is not a positive event for it in many ways, including the possibility of adverse publicity, the possible expense of redoing an audit, and more."
The agency’s focus on gatekeepers goes back to at least October 2013, when White, in a speech before the Securities Enforcement Forum, made clear that firms that work with investment advisers cannot escape enforcement actions by stating that they are not the adviser. "We are . . . pursuing those who should be serving as the neighborhood watch, but who fail to do their jobs," she said. "Cases against delinquent gatekeepers remind them, and the industry, of the important responsibilities that gatekeepers share with us to protect investors."
Custody requirements and independence
Voit had custody of fund-invested client assets from at least December 2013 to December 2015 and therefore was required to comply with the Custody Rule.
Among other things, the Custody Rule requires that advisers maintain client assets with a qualified custodian, "who must provide account statements to investors at least quarterly, and requires client assets to be verified through an annual surprise examination by an independent public accountant," the SEC said. The adviser, however, in what is known as the "audit exception," does not have to comply with certain requirements if it provides limited partners with annual audited financial statements prepared in accordance with GAAP within 120 days of the end of the partnership’s fiscal year.
"The financial statements must also be audited in accordance with generally accepted auditing standards," the agency said. The financial statements are required to be audited by an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, by the PCAOB (emphasis SEC) .
And therein lies the rub. "WKMR was not independent because it both prepared and audited the funds’ 2014 and 2015 financial statements and notes to the financial statements, which it then audited," the agency said in the settlement order.
Under Rule 2-01(c)(4)(i) of Regulation S-X, which governs the specific form and content of financial reports, the SEC said, "an accountant is not independent if he provides certain bookkeeping or other services, related to the accounting records of financial statements unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements."
"The financial statements and accompanying notes that WKMR prepared were subject to the audit procedures that WKMR performed during its audit of the funds," the agency said. It noted that the WKMR engagement team, after analyzing whether WKMR’s preparation of the financial statements and notes impaired the accounting firm’s independence, "erroneously concluded that independence was not impaired." Nor, the SEC said, did WKMR provide any analysis to support this conclusion.
The second reason the settlement provided as to why WKMR could not be considered independent was that the accounting firm "had a direct business relationship with Voit."
It turns out that a WKMR investment adviser affiliate, WKMR Financial, "had a referral fee arrangement," the agency said. The main advisory service provided by WKMR Financial included recommending other investment management firms, including Voit, to its clients. WKMR, in exchange for these recommendations, "received a percentage of the annual fee that the investment adviser receive[s] from those referred clients," the SEC said. "WKMR Financial did not receive any referral fees from Voit if the client did not become an investment management client, nor did it receive any referral fees for referring clients who invested in the Voit funds."
Disrud and Sehmer, since they were WKMR partners, were also indirect owners of WKMR Financial – which meant that they would receive a portion of the income that the affiliate generated.
"Under Rule 2-01(c)(3) of Regulation S-X, accountant is not independent if it has a direct business relationship with an audit client," the agency said. "WKMR had a direct business relationship with Voit because WKMR Financial . . . provided advisory services and recommended Voit to its clients and, in exchange, received a fee from Voit." That fee amounted to most of the affiliate’s revenue, according to the settlement order. "For 2014 and 2015, all of WKMR Financial’s income came from Voit, and WKMR’s net income for 2014 and 2015 was approximately $217,000 and $233,000, respectively." The SEC also alleged that the WKMR engagement team did not analyze whether the accounting firm was considered to have a direct business relationship with its audit client.
As mentioned above, financial statements, are required, among other things, to be subject to regular inspection the PCAOB. According to the SEC, this was not the case with WKMR, which, as of the beginning of the 2014 and 2015 funds’ engagement periods, "was not subject to regular PCAOB inspection."
Charges and punishment
As part of the settlement, WKMR and Disrud were found to have caused, and willfully aided and abetted, Voit’s 2014 and 2015 violations of Section 206(4) of the Advisers Act and its Rule 206(4)-2, the Custody Rule. Sehmer was found to have caused Voit’s 2015 violations of Section 206(4) and the Custody Rule.
WKMR was banned from working before the Commission as an accountant for one year, ordered to pay disgorgement and prejudgment interest of more than $18,800, and a civil money penalty of $15,000. Disrud was banned from working before the Commission for two years and ordered to pay disgorgement and prejudgment interest of more than $10,000 and a civil money penalty of $10,000, and Sehmer was banned from working before the Commission for one year.
An attorney representing WKMR and its two partners did not respond to a voice mail or an email seeking comment.