In the wake of Bernie Madoff's monumental, $60 billion Ponzi scheme, regulators are proposing to increase accounting safeguards by requiring mandatory surprise audit inspections of every investment adviser with custody of client assets.

The Securities and Exchange Commission's proposed amendments to Rule 206(4)-2 would require all registered investment advisors with custody of client assets or securities to undergo an annual surprise examination by an independent public accountant. The public comment period on the proposals ends July 28.

"The proposals come in the aftermath of several high-profile enforcement actions brought by the SEC against registered investment advisors and broker/dealers alleging misappropriation and other misuse of investor assets," said Mike Rosella, chairman of the investment management practice at the international law firm Paul Hastings.

"These recent enforcement actions have led the SEC to conclude that additional safeguards relating to the custody of client assets are appropriate," he said.

Mutual funds already have independent surprise audits and will not be impacted by these amendments, Rosella said, but many private accounts, hedge funds and funds-of-funds have previously been exempted if their qualified custodian sends account statements directly to clients.

"The SEC believes that the annual surprise examination by an independent public accountant would provide another set of eyes on client assets, resulting in the additional protection against their misuse," said a Deloitte report on the proposed rule changes.

Stopping the Next Madoff

No one can say whether these proposed amendments will stop the next Madoff-like Ponzi scheme or just add another layer of expensive bureaucracy, but additional safeguards will certainly increase transparency into these funds.

Since 1991, Madoff had the auditing firm Friehling & Horowitz look at his books periodically, but that firm is currently under criminal investigation for fraud.

The tiny Friehling & Horowitz, which operates out of a small office next door to a pediatrician in New City, N.Y., has been telling the American Institute of Certified Public Accountants for 15 years that it doesn't conduct audits. The only active accountant is David Friehling, 49, who people said rarely came into the office, according to news reports. Friehling's signature appears on Madoff's recent audit reports.

Rosella did not want to say that Friehling was aware of or participated in Madoff's fraud until all the facts are in, but said "a real accounting firm would have prevented this."

Auditors are supposed to do a direct confirmation of every investment in the fund, including physical examination of securities and cash, verifying the books and records of client accounts and confirming these numbers with clients.

"Even an incompetent auditor doing a surprise inspection of the vault could have seen that the vault was empty," Rosella said.

The new proposals don't do much to address the problem of having a competent auditor, he said. Auditors must be certified public accountants, but they don't have to have any expertise in funds.

The proposed rule changes say the annual surprise examination needs to be performed by an independent public accountant who is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Following the examination, the accountant would be required to file Form ADV-E and an examination certificate to the SEC within 120 days, the Deloitte report said.

"If, during the course of an annual surprise examination, the independent public accountant discovers a material discrepancy, the accountant would be required to notify the SEC of such a finding within one business day," Deloitte said.

The proposed rule requires registered advisors with custody of client assets to "have a reasonable basis for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which the qualified custodian maintains funds or securities."

"The SEC believes that the direct delivery of statements by the qualified custodian will provide greater assurance of the integrity of those account statements," Deloitte said.

Under the proposed rules, there is still an exception that allows pooled investment vehicles such as hedge funds to avoid having a qualified custodian send quarterly account statements to investors as long as the pool is audited annually by an independent public accountant, the Deloitte report said.

The proposed rules also require an annual written SAS 70 Type II internal control report filed by an independent public accountant if the custodian does not maintain client assets but outsources the job to an adviser or third party. The internal report would address the inherent conflict of relying on custodial reports issued by the adviser.

Without an internal report, "there is a greater risk that the custodian could be a party to any fraud and therefore the custodian's reports could be compromised," the SEC said.

A Transparent Future

Madoff was able to perpetuate his fraud for so long because he demanded unwavering trust and loyalty from his clients. If an investor asked to see the books, Madoff would boot them out of the fund.

The "extraordinarily evil," as the judge put it, 71-year-old Madoff is safely behind bars, beginning his 150-year prison sentence, and Friehling awaits trial this month on charges of enabling Madoff's fraud by falsely certifying audit reports, but locking up these two men and throwing away the keys won't be enough to discourage future fraud.

Rosella said investors must not put up with such strict secrecy in the future.

"Clients should demand to know who the auditors are," he said. "Know your advisor, and know your advisor's auditor."

Legitimate hedge funds have real auditors, he said, but this is not a requirement, nor is it a requirement for private accounts.

"In theory, funds should want to have competent people, but in the hedge fund and private account space, the expertise of the auditor is not reviewed," Rosella said. "You don't want advisers hiring cheap auditors, but this would be very awkward to write into regulations."

Rosella said he expects the proposed changes to slide through without much controversy.

(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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