Regulators are looking for ways to increase accounting safeguards for investment advisors who have custody of client assets, but an investment advisor's group says some of the proposed changes are too broad and go too far.
Proposed amendments to Rule 206(4)-2, requiring all investment advisors that control or have custody of client assets to hire an independent public accountant to conduct an annual "surprise" examination of their books, would place an unnecessary burden on small advisory firms, according to the Washington-based Investment Adviser Association.
"The surprise audit requirement would apply to all advisors considered to have custody under the rule, whether or not they serve as qualified custodians that actually hold client assets," said Valerie Baruch, the IAA's assistant general counsel, in a letter to the Securities and Exchange Commission.
The best way to make sure an advisor is actually doing what they say is to have an independent third party check their books, according to the SEC. Baruch agrees that getting independent verification of account information is critical, but if an advisor already uses an independent custodian, such a requirement would be redundant and unnecessary, she said. "We do not believe such a requirement is warranted when client assets are held by independent third-party custodians," she said.
Baruch said the proposed requirements make sense for checking up on advisors like Bernard Madoff who have self custody and hold client assets directly. Madoff is perhaps the best example of why the rules should be changed, she said.
Madoff was sentenced to 150 years in prison in June after pleading guilty to perpetrating a massive Ponzi scheme that victimized thousands of investors. He was able to slip past the SEC for nearly two decades partly due to his stellar reputation, penchant for secrecy and his creative knack for keeping anyone from doing a thorough audit of his books and records.
Like a character from a Dostoyevsky novel, Madoff kept expecting to get caught, and wanted law enforcement officials to catch him before he gave up. Ultimately, the financial crisis forced Madoff's hand, and he turned himself in.
Clearly, if the SEC is to prevent another Madoff, far more intense vigilance is needed, rather than a mere change to the custody rule.
The Commission staff bungled numerous investigations into Madoff's activities over the years, repeatedly failed to act on tips and red flags they uncovered and accepted Madoff's explanations for account inconsistencies, even when his answers seem evasive or contradictory, according to a report issued last week by the SEC's Office of Inspector General. On several occasions, SEC investigators drafted letters that would seek independent, third-party verification of Madoff's operations, but the letters were never sent due to the amount of paperwork such a request would entail.
Inspector General H. David Kotz found that Madoff took advantage of the SEC's inexperience and ineptitude to promote his fund, telling investors that the SEC had examined his records and found no evidence of fraud.
"The fact the SEC had conducted examinations and investigations and did not detect the fraud lent credibility to Madoff's operations and had the effect of encouraging additional individuals and entities to invest with him," the report said.
Madoff hired the tiny auditing firm Friehling & Horowitz to look over his incredibly complicated and secretive records. Even though the firm signed Madoff's audit reports for nearly 17 years, it did not register with the Public Company Accounting Oversight Board, did not participate in the required peer review by other accountants and told the American Institute of Certified Public Accountants that it didn't conduct audits.
In 2006, Madoff told investigators all his trades could be verified by checking his account at the Depository Trust Company (now the Depository Trust and Clearing Corp.) and even provided investigators with his account number, the report said. During his trial this year, Madoff said he was astonished that the SEC never called his bluff and checked with DTCC.
"A simple inquiry to one of several third parties could have immediately revealed the fact that Madoff was not trading in the volume he was claiming," the Inspector General's report said.
An annual surprise examination performed by an independent public accountant who is registered with and subject to regular inspection by the Public Company Accounting Oversight Board could provide another set of eyes on clients' assets and offer additional protection against the theft and misuse of funds, the SEC said. Following the examination, the accountant would be required to file Form ADV-E and an examination certificate to the SEC within 120 days.
Baruch said she is concerned the requirements apply too broadly to all related persons of advisors, regardless of the relationship between the advisor and its affiliated entity.
According to the SEC, 90% of the more than 11,000 registered investment advisor firms have fewer than 50 employees, and 68% (more than 7,500 firms) have 10 or fewer employees.
"Compliance is always a big concern for small advisors," Baruch said. "Our argument is that these changes are too expensive and unnecessary. This proposal could put many small advisors out of business."
The SEC estimates the cost of surprise audits to be about $8,100. Baruch said this number is essentially the same estimate as a similar proposal in 2002, and does not reflect price increases in the past seven years. In reality, she said, the cost could be much higher, particularly for hedge funds or other alternative investment firms that handle complex securities.
"The Commission's cost estimate should be adjusted to account for factors that will have a significant impact on the cost of the surprise audit, including the size of the advisor and the complexity of the advisor's business, the number of clients an advisor has, the number of investment holdings, the number of custodians holding client assets and the types of securities held by the clients," she said. "Given those considerations, more realistically, it is our understanding that the surprise audits are likely to cost between $20,000 and $300,000.
"The IAA strongly opposes imposition of the surprise audit requirement on the almost 6,000 advisors that are deemed to have custody solely because they have the authority to deduct fees from client accounts," Baruch continued. "Adequate additional safeguards already exist for these arrangements. Advisors that have the authority to deduct fees from client accounts have extremely limited access to client assets."
The public comment period on the SEC's proposals ended July 28, and the SEC is now considering the changes.
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