Investment advisers whose only fees are deducted from client accounts — and do not have custody of assets — will not be subject to additional exams under a regulation expected to be approved today by the Securities and Exchange Commission.
The SEC will require advisers who have some form of custody to undergo surprise exams and custody control reviews.
That group includes advisory firms that have physical custody of client assets and firms that keep client assets with a custodian that is affiliated, but not operationally independent.
If a client's assets are handled by a custodian that is affiliated, but operated independently, that custodian would be subject to custody controls reviews — but not the annual surprise audit exams.
An adviser who relies on an independent custodian but has the authority to withdraw clients' funds would be subject to surprise audits. The adviser would not be subject to custody controls reviews under the plan devised by the SEC.
Under the new rules, about 1,900 of the approximately 11,300 advisory firms registered with the SEC will be required to obtain surprise audits. That number is likely to drop if legislation now in Congress that would raise the asset threshold for SEC registration to $100 million from $25 million becomes law.
The new audit rules “grow out of the Madoff Ponzi scheme and other frauds in which investor assets were misappropriated by investment advisers,” SEC Chairman Mary Schapiro said in a statement. “Such frauds have caused investors to question whether their assets are safe when they entrust them to an investment adviser. I believe today's rules will help put their minds at ease.”
The surprise audit provision for advisers that collect fees solely from client accounts, who sent hundreds of negative comment letters to the SEC.
While most advisers do not maintain physical custody of client assets, in some situations “there is heightened opportunity for an adviser to misappropriate a client's assets and convert those assets to their own personal use,” Ms. Schapiro said.
In scrapping the surprise audit plan for firms that deduct fees, the commission acknowledged that the non-custody advisory model “has not, to date, presented the same opportunity for fraud and misappropriation” as situations where advisers exercise more control over client assets.
Firms that are subject to custody controls review will be required to obtain a written report prepared by an accounting firm registered and inspected by the Public Company Accounting Oversight Board that describes controls in place at the custodian and tests the effectiveness of the controls. Such reports are referred to as “SAS-70” reports.
Commissioner Luis Aguilar supported the rule, but he was critical that the SEC has not moved to tighten custody rules governing broker-dealers. The Madoff firm was registered only as a brokerage firm, inspected by what is now the
Financial Industry Regulatory Authority Inc., for decades while it carried out its massive Ponzi scheme, he noted.
"This package of proposals is going to be heralded as the Madoff fix. But we need to recognize that this is just an incremental step, and there is much more that needs to be done," he said. He said he was disappointed that the proposals did not include new measures aimed at custody of assets held by broker-dealers.
"Even if today's rule had been in effect, it would not have applied to the Madoff broker-dealer that existed for the duration of the fraud," he said. "It is impossible for me to have confidence that other fraudsters can not continue to operate as broker-dealers and exploit some of the same weaknesses to end-run Finra and to end-run the SEC."
He called for new staff proposals to strengthen broker-dealer custody rules. The vast majority of investor assets in the United States are not held by investment advisers, he added.
Further, requiring many of the auditors to be governed by the Public Company Accounting Oversight Board will have little impact until Congress authorizes the PCAOB to fully inspect the auditors, he said.
The cost of the surprise exam to advisers who use independent custodians but can withdraw assets, such as when they serve as trustees or act as power of attorney for clients, may be overly burdensome, Mr. Aguilar said.
But Ms. Schapiro defended the plan to subject those advisers to surprise audits. She noted that In four cases brought over the past year, investment advisers who used independent custodians but who had discretion over client funds embezzled "very significant sums of money" from elderly and mentally-incapacitated clients. "Requiring those advisers to go through a surprise examination is the least we can do for [such clients]," she said.
