On September 30, 2021, the Division of Enforcement of the Securities and Exchange Commission (the “SEC”) sanctioned and fined Redwood Wealth Management LLC (“Redwood”), an investment adviser, for its failure to maintain client funds with a qualified custodian.
Through this action, the SEC is sending a strong signal to advisers that it is actively searching for Custody Rule (as defined below) violations and that it is willing to take action, even in the absence of actual harm.
The SEC’s orders found that Redwood violated Rule 206(4)-2 (the “Custody Rule”) of the Investment Advisers Act of 1940 (the “Advisers Act”), which is designed to protect investment advisory clients from the misuse or misappropriation of their funds and securities. The Custody Rule requires advisers registered with the SEC:
(i) to maintain client funds and securities with a qualified custodian;
(ii) to have the qualified custodian send account statements directly to advisory clients
(iii) to undergo an annual surprise examination by an independent public accountant to verify client assets; and
(iv) unless client assets are maintained by a custodian that is not the adviser itself or a related person, to obtain a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board.
Background
In 2019, a company (the “Mortgage Company”) owned and controlled by one of Redwood’s clients desired to raise more money for additional capital to help support the Mortgage Company’s rapid growth.
Redwood suggested to the Mortgage Company’s CEO that some of its high-net-worth clients could lend the Mortgage Company funds at a generous interest rate.
To do so, Redwood proposed lines of credit secured by the clients’ advisory accounts held at Redwood.
Several Redwood clients invested a total of $30 million and promissory notes were issued by the Mortgage Company.
In late 2019, the Mortgage Company repaid all of the Redwood clients who invested in promissory notes early and in full.
No Redwood client lost money in the promissory note investments.
The Violation
The SEC argued that the promissory note investments were improperly held outside of the Redwood clients’ managed accounts. Moreover, the clients’ periodic account statements did not reflect the promissory note investments.
Consequently, because the promissory note investments were not held by a registered broker dealer and were not listed on client account statements, neither the Redwood CCO nor the CIO were aware of the promissory note investments, and had no ability to monitor or evaluate the propriety of the investments as required by Redwood’s policy manual, and therefore, undermined the investor protection goals underlying the Custody Rule.
It is important to note that prior to this incident, (i) Redwood client securities were generally held in investment accounts at a registered broker dealer; and (ii) Redwood’s policies and procedures also ensured that the CCO and CIO had the opportunity to “review accounts in order to identify any accounts that may be managed in a manner that is inconsistent with the objectives and guidelines established by the client.”
In response to the failure to hold the notes in an approved custody account, the SEC brought this action against Redwood for (i) failing to maintain client assets with a qualified custodian and (ii) failing to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.
Without admitting or denying the findings, Redwood agreed to pay $70,000 in fines and appoint an independent compliance consultant to conduct a review of Redwood’s implementation of its compliance policies and procedures.
If you have any questions about this alert, or any other regulatory matters, do not hesitate to reach out to Daniel Viola (Partner – Head of the Regulatory Group) at 212.573.8038 or via email at dviola@sadis.com, or to Nicole Arrow (Associate) at 212.573.8148 or via email at narrow@sadis.com.
