SEC Action: In July 2018, the SEC instituted administrative cease and desist proceedings resulting in a censure and a fine of $75,000 against New Silk Route Advisors, L.P. (“NSR”) for failing to send annual audited financials to its private fund investors within 120 days of its fiscal year end.[1]
Background: Rule 206(4)-2 under the Advisers Act (the "Custody Rule") imposes certain requirements on registered investment advisers that have custody of client funds or securities. The rule defines custody as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. When advisers are general partners (“GP”) or managing members (“MM”) to private funds or have affiliates who serve as GP or MM to a private fund, they have control and thus have “custody”. The Custody Rule provides advisers to private funds with two different methods to comply when the adviser is deemed to have “custody” of private fund assets: (1) the “surprise examination”, by which an independent public accountant verifies client funds and securities at least once on a surprise basis during each calendar year, or (2) the “audit exception,” under which an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”), conducts an annual audit in accordance with GAAP with the adviser delivering the audited financial statements within 120 days of the fund’s fiscal year end. Fund advisers utilizing the audit exception are exempt from the “account statement “ requirement, whereas fund advisers utilizing the “surprise examination” must have a reasonable basis for believing that the qualified custodian sends quarterly account statements to each investor. Fund of funds, which are defined as a pooled investment vehicle that invests 10% or more of their assets in unaffiliated pooled investment vehicles, may distribute audited financial statements within 180 days of its fiscal year end.
Case Details: NSR arranged for a PCAOB-registered firm to conduct the audits of the combined and consolidated financial statements for the NSR Funds and subsequently received unqualified audit opinions for each year. However, NSR failed to distribute the annual audited financial statements to the investors in the NSR Funds within the required timeframes, see table below:
| Fiscal Year | Calendar Days Late |
| 2012 | 42 |
| 2013 | 22 |
| 2014 | 18 |
| 2015 | 37 |
| 2016 | 245 |
| 2017 | 6 |
The SEC went on to state, despite missing the audited financial statement distribution deadline, NSR did not make material changes to its processes related to the audits. As a result, the SEC cited NSR with both a violation in the Custody Rule as well as 206(4)-7 for failure to adopt written policies or procedures reasonably designed to prevent violations.
The SEC has previously issued guidance stating, “it would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances.”[2]
When NSR did not make material changes to its processes related to the audits for 2013 through 2017 after missing the audited financial statement distribution deadline in subsequent years, the delays in the distribution by NSR were not due to “unforeseeable circumstances,” and “attempts to rely on the Custody Rule FAQ by NSR would have been unreasonable.”
Conclusion: The financial penalties to advisors, as well as harm to their reputation, for failure to timely deliver audited financial statement to its private fund investors can be substantial even when the audits do not have a qualified opinion. Advisors do not always have complete control over the accountants that they hire and there are additional challenges for fund of funds when you are relying on another entity to provide their own audits. However, when advisors experience an unforeseen late audit report from the accountant they should document the steps they have taken to ensure the late audit does not happen again. Such actions may include: having the accountant start the audit earlier, change the fiscal year end to a time when accountants are less busy, or if necessary, replace the accountant with one that you believe will be able to complete the report in a timely basis.
[1] https://www.sec.gov/litigation/admin/2018/ia-4970.pdf
[2] https://www.sec.gov/divisions/investment/custody_faq_030510.htm
https://www.ncsregcomp.com/team/doug-kamin