In an effort to weed out the seemingly endless supply of Ponzi schemes and other financial-related fraud, the SEC recently approved changes to the custody rule that applies to SEC-registered investment advisers. The final rule goes into effect on March 12. The new rule tightens supervision of RIAs, who now must undergo annual surprise audits, with limited exceptions, to ensure their business is not just another Ponzi scheme masquerading as a legitimate enterprise.
Most investment advisers do not maintain physical custody of their client’s assets. Instead, a qualified, independent third-party custodian, such as a regulated bank or broker-dealer, often holds those assets. However, many advisers have authority to withdraw funds from these custodial accounts. Over the past year, the SEC has brought numerous enforcement actions against advisers who had access to their clients’ assets and misused them. These advisers often covered up the misappropriation by distributing false account statements reflecting assets that did not exist. Approximately 200 Ponzi schemes were uncovered over the past two years, according to an Associated Press analysis.
According to SEC Chairman Mary Schapiro, the amended custody rule provides "additional safeguards where the safeguards are needed most–that is, where the risk of fraud is heightened by the degree of control the adviser has over the client’s assets." The numerous Ponzi schemes discovered over the last two years "have caused investors to question whether their assets are safe when they entrust them to an investment adviser." Schapiro believes that the enhanced custody rule will help put investors’ minds at ease.
Not all at the SEC agree that the amended rule satisfactorily accomplishes its intended goals. Commissioner Luis Aguilar expressed concern that the rule, while a "step in the right direction," did not go far enough. Aguilar was critical that the SEC has not yet moved to tighten the custody rules surrounding broker-dealers–especially since the Madoff firm was a registered broker-dealer for nearly two decades before it registered as an investment adviser in 2006. He is concerned that the amended rule will be heralded as "the Madoff fix" and will "lull investors into a false sense of comfort."
Aguilar’s concerns are well-founded. The new rule may be a small step forward, but the SEC needs to do a great deal more.
The following are the highlights of the new custody rule–Rule 206(4)-2 of the Investment Advisers Act:
Expanded Definition of Custody. The SEC has clarified that an advisor has custody of client funds when it physically possesses the funds or has authority to obtain possession, as well as when a "related person" of the advisor has such authority.
Surprise Exams. RIAs with custody of their client’s assets or whose client assets are held by an affiliated custodian that is not "operationally independent" now must undergo an annual surprise examination by an independent public accountant to verify that the money claimed to be in customer accounts actually exists. If funds are discovered to have gone astray, the auditors are required to notify the SEC. When an adviser, or a related person, acts as the qualified custodian ("self-custody"), the surprise examination must be performed by a PCAOB-registered accountant. An adviser that does not "self-custody" can use any independent public accountant.
Custody Controls Reviews. In circumstances where the RIA, or a related person, acts as the qualified custodian–whether or not operationally independent–the RIA also will be subject to a custody controls review and will be required to obtain, at least annually, a written report, prepared by a PCAOB-registered auditor, that describes the internal controls in place at the custodian, tests the effectiveness of such controls and provide the results of those tests (typically, a "SAS-70 Report"). Advisers to pooled investment vehicles that "self-custody" must obtain such a report even if exempted from the surprise audit and the account statement requirements.
Direct Delivery of Account Statements. Qualified custodians maintaining client assets must now send account statements directly to advisory clients in all cases, even if the adviser itself sends account statements. The rule eliminates the current alternative that allows audited advisors to send account statements to clients in lieu of the qualified custodian. In addition, any account statements sent by an adviser now must "urge" clients to compare such statements with those from the qualified custodian.
Exemption for Advisers to Pooled Investment Vehicles. Advisers to hedge funds and other private funds that are subject to annual financial statement audits and that distribute those audited statements, prepared in accordance with U.S. GAAP, to its investors are deemed to have satisfied the surprise audit requirement. The audit must be performed by an independent PCAOB-registered accountant.
The SEC expressed concern that under the amended rule an advisor to a pooled investment vehicle is not required to have a reasonable belief that the qualified custodian delivers account statements to its investors. Consequently, the SEC has directed its staff to explore additional methods to further protect investors in those vehicles.
Exemption for RIAs Who Only Deduct Fees. RIAs whose managed assets are in the custody of an independent, third-party custodian, and either have no control over the funds or merely have authority to withdraw their agreed-upon advisory fees are exempted from the surprise audit requirement and the custody controls review.
Although "surprise audits" may sound menacing, they likely will have very little impact on financial fraudsters. They certainly will increase the back office expense to advisors, particularly with regards the addition of controls review. To be fair, back office operations probably merit tighter controls, and the rule will encourage greater adoption of third-party custodians. However, the SEC needs to do more to protect investors, including extending similar rules into the broker-dealer regulatory world. I agree with Commissioner Aguilar that many investors will view these rule changes as a quick fix to fraud in our markets. Unfortunately, things aren’t quite that simple. Time will tell whether these amendments will have any substantive impact on investor protection.
Beth Lowson is senior securities counsel with The Nelson Law Firm, LLC in White Plains, N.Y. She can be reached at bnlowson@nelsonlf.com.
