Hedge Fund Adviser Sanctioned for Delivering Audited Financial Statements After the Custody Rule Deadline

October 29, 2014

The SEC brought an enforcement action against Sands Brothers Asset Management, LLC (SBAM), Steven Sands, Martin Sands and Christopher Kelly failed to timely distribute audited financial statements to the investors of hedge funds managed by SBAM in violation of Rule 206(4)-2 under Section 206(4) of the Advisers Act – the “custody rule”. In 2010, SBAM was the subject of a settled administrative proceeding, In re Sands Brothers Asset Management LLC, et al., Release No. 3099 (Oct. 22, 2010), by which the SEC censured SBAM, ordered it to cease and desist from violating the Advisers Act, including Rule 206(4)–2, and ordered it to pay a $60,000 civil money penalty. The SEC also found that they violated the 2010 order by failing to implement any procedures or safeguards to ensure compliance with that Rule.

Rule 206(4)–2 is designed to protect investor assets. The custody rule requires that advisers who have custody of client assets put in place a set of procedural safeguards to prevent loss, misuse or misappropriation of those assets. An adviser has “custody” of client assets if it holds, directly or indirectly, client funds or securities, or if it has the ability to obtain possession of those assets. An adviser who has custody must, among other things: (i) ensure that a qualified custodian maintains the client assets; (ii) have a reasonable basis for believing that the qualified custodian sends quarterly account statements to clients; and (iii) ensure that client funds and securities are verified by actual examination each year by an independent public accountant.

The custody rule provides an alternative for advisers to pooled investment vehicles. In relevant part, the rule prescribes that an adviser “shall be deemed to have complied with” the independent verification requirement if the adviser “distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year.” The accountant performing the audit must be an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board. Id. An adviser that takes this approach is also not required to satisfy the account statements delivery requirement.

The SEC found that SBAM neither submitted to a surprise examination, nor distributed its audited financials in the 120-day window imposed by the rule. Indeed, SBAM took no remedial action in response to the 2010 Order to implement policies or procedures aimed at ensuring compliance with the custody rule. For the period 2010 through 2012, SBAM had custody of client assets within the meaning of Rule 206(4)–2(d)(2). At no time from 2010 through the present has SBAM submitted to a surprise examination by an independent public accountant. The SEC stated that SBAM distributed its funds’ audited financial statements for the fiscal years 2010 – 2012 after the 120-day custody rule deadline.

According to the SEC, the circumstances that led the audits to be delayed were predictable and not unforeseeable. As SBAM’s auditors noted with respect to the audit for the fiscal year 2012, there was a delay in the timely receipt from [SBAM] management of the information supporting the valuation of non-performing loans which significantly affected the completion of the audit and the timely issuance of the financial statements. The SEC concluded that conditions underlying that delay were known or identifiable before the commencement of the audits and therefore a more proactive timely approach by your valuation staff in identifying these situations and obtaining the necessary documentation could alleviate most of the audit issues. Indeed, the auditors had repeated difficulty obtaining the information they needed to value the same portfolio companies year over year. This was so even though for some of those companies, Steven Sands and/or Martin Sands served on the company’s board, and for one such portfolio company, Christopher Kelly acted as President and Chief Executive Officer.

As a result of the conduct described above, SBAM willfully violated Section 206(4)–2 of the Advisers Act and Steven Sands, Martin Sands and Christopher Kelly willfully aided and abetted and caused SBAM’s violations of Section 206(4) of the Advisers Act and Rule 206(4)–2 thereunder.

Click http://www.sec.gov/litigation/admin/2014/ia-3960.pdf for the enforcement action.


Investment Advisers, Investment Companies