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SEC Charges Alt Fund Adviser with Custody Violations

Posted in Investment Adviser Regulation, SEC Enforcement

The Securities and Exchange Commission on February 12, 2015, entered findings against an investment adviser to several alternative mutual funds for maintaining $247 million in cash collateral at broker-dealer counterparties instead of the fund’s custodial bank.  The SEC staff discovered the alleged violations during a routine examination.  Without agreeing with or denying the charges, the adviser agreed to pay a $50,000 penalty to settle the SEC’s charges.

The SEC charged that the adviser violated the custody requirements of Section 17(f)(5) of the Investment Company Act of 1940 because it did not ensure that the funds’ custodial bank maintained the cash collateral held by broker-dealer counterparties.  The cash collateral related to the funds’ investments in total-return and portfolio-return swaps.

The SEC’s order found that the investment adviser also violated Section 12 of the 1940 Act and related Rule 12b-1(h) because it failed to implement directed brokerage policies and procedures, which required the adviser to create and maintain an approved list of executing brokers for the funds, and to monitor the funds’ compliance with the directed brokerage requirements.  In addition, the SEC found that the adviser caused the managed funds to violate Rule 38a-1, the Investment Company Act compliance rule.

Our take – This settlement appears to be the fruit of the SEC’s sweep examination of alt funds.  We expect to see more similar enforcement cases.  The case reinforces the need to ensure that funds follow their established compliance policies, and to not lose sight of the basics, such as compliance with the custody rules.  In the case of this type of cash collateral, funds typically comply with the custody rules by establishing a tri-party agreement among the fund, the counterparty, and the fund custodian.