This state's advisers fumble custody requirements

Transition from SEC to state securities regulation unveils multiple misunderstandings

Nov 14, 2013 @ 1:41 pm

By Mark Schoeff Jr.

Many investment advisers in Massachusetts who moved from oversight by the Securities and Exchange Commission to the state failed to disclose that they have custody of client assets, according to a new study by the state's securities regulator.

A report released Thursday said that only three of the 102 Massachusetts-based advisers who made the switch had been examined by the SEC in the three years prior to their move to state regulation last year.

Massachusetts examined 50 of those switching advisers between August 2012 and last month and found 18 custody deficiencies. Only 14 of the advisers acknowledged having custody before the examination.

Massachusetts Secretary of the Commonwealth William Galvin is zeroing in on advisers' direct access to client funds because it was a key issue in Bernard Madoff's multibillion-dollar Ponzi scheme.

He doesn’t necessarily anticipate that one of the switching advisers could become the next Madoff. But he is trying to stop abuse of custody authority for investors at all levels.

“The amount of money is not the determining factor,” Mr. Galvin said. “It’s whether they’re at risk of having money misused.”

The report said that because of the “higher potential of investor harm,” regulatory action is appropriate.

Unlike the SEC, Massachusetts does not exempt an adviser from custody compliance rules if he or she is the executor or a trustee of a trust for a family member or personal friend. The state also deems an adviser to have custody if he or she directly deducts fees from client accounts without filing an invoice.

The Massachusetts report asserted that advisers who switched regulatory bodies did not grasp custody rules in general.

“The SEC's failure to examine a majority of the switch advisers presumably contributed to the switch advisers' misunderstanding of the custody rule requirements,” the report states. “Furthermore, the division's recent examinations have demonstrated that many advisers do not have a complete understanding of what custody actually entails.”

Among other things, if an adviser has custody, he or she must submit to an annual surprise examination by an accounting firm registered with the Public Company Accounting Oversight Board.

The report also said that many of the advisers migrating to Massachusetts oversight had never been subjected to a books-and-records review.

Mr. Galvin said he is not pointing a finger at the SEC and empathizes with the budget challenges the agency faces in expanding its examination coverage of investment advisers. He said bolstering SEC resources is a key to stopping a future rogue adviser.

“Some of the misdeeds of the recession are receding in people’s minds quickly,” Mr. Galvin said. “The SEC is the national regulator and they should be adequately funded.”

Advisers who haven't been examined, whether they're switching to the states or remaining with the SEC, need to brace themselves, according to Steven Thomas, director of compliance at Lexington Compliance, a division of RIA in a Box.

“These firms are going to have a rude awakening,” said Mr. Thomas, a former South Dakota securities regulator. “They're going to see a lot of deficiency letters. You're going to see a lot of books-and-records violations.”

Under the Dodd-Frank financial reform law, about 2,100 investment advisers with assets under management of $25 million to $100 million switched from SEC to state oversight.


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