In an attempt to prevent the next big investor rip-off, the Securities and Exchange Commission is targeting investment advisers who are stumbling over a regulation de-signed to prevent them from stealing client money.
In an investor alert last week, the SEC said that roughly one-third of advisory firms examined last year — about 140 — were flagged for problems with how they held or had access to their clients' assets.
“We found some pretty significant deficiencies,” Carlo di Florio, director of the SEC's Office of Compliance Inspections and Examinations, told an audience at the Investment Adviser Association's compliance conference last Thursday. “Clearly, people are struggling with different dimensions of the custody rule.”
OUTSIDE COMPANY
That regulation was put in place in 2009 in response to the $65 billion Ponzi scheme perpetrated by Bernard Madoff, who maintained control of his client funds himself. Most investment advisers house their clients' assets with an outside company such as
Fidelity Investments, Foliofn Inc., Pershing LLC, TD Ameritrade Holding Corp. or The
Charles Schwab Corp.
The SEC exams, however, found that many advisers didn't know that they had inadvertently become custodians. The designation can be triggered by serving as a trustee for a client, signing checks on a client's behalf or withdrawing funds from client accounts to pay bills, among other things.
A problem for financial advisers who knowingly maintained custody is that they failed to submit themselves to a surprise annual exam by an independent auditor. The SEC discovered that too often, these reviews were planned.
Furthermore, advisers who use a qualified custodian were cited for commingling client, proprietary and employee funds, and failing to ensure that quarterly custodian reports were sent to clients.
In most of the cases, the SEC worked with advisers to address the situation, while some were forwarded to the agency's enforcement unit. The agency did not identify the 140 violators.
“It's a big worry,” Mr. di Florio said. “The custody rule was put in place to protect against Madoff-type issues. Whether there's a fraudster behind [a violation] or not will depend on facts and circumstances. The intent of the commission was to say, "Let's take that risk off the table.'”
The exam results don't mean that there are many looming Madoff situations, according to one compliance expert. Instead, advisers tripped over subtle custody triggers.
“Most of these firms couldn't be Bernie Madoff if they wanted to,” said Dan Bernstein, director of research and development at MarketCounsel LLC.
INNOCENT MISTAKES
Custody violations tend not to be dramatic, according to Steven Thomas, director of Lexington Compliance, a division of RIA in a Box LLC.
“My personal experience has been that the majority of custody findings were more procedural-based than customer harm situations,” said Mr. Thomas, a former South Dakota chief compliance examiner. “It's not actual pilfering of client money that's the concern; it's the dotting of an I and crossing of a T of required procedures.”
One investment adviser said she is not surprised that fellow advisers are having trouble with custody requirements.
“It's a complex rule,” Wendy Laidlaw, vice president of R.M. Davis Inc., said on the sidelines of the IAA conference. “There are a lot of nuances. I can understand people getting caught off guard in an audit. Many haven't deliberately violated the rule.”
She looked at the alert as Mr. di Florio recommended.
“It helped us assess whether we are ourselves aware of the variety of ways we could have custody,” Ms. Laidlaw said. “It's not a major issue for us, because we're on top of it.”
But it takes just one slip to result in an adviser's being labeled a custodian.
“Doing it once is as bad as doing it 20 times,” said Patrick Burns, managing attorney at an eponymous law firm. “If you do it even once, you now have custody.”
But avoiding custody land mines shouldn't be a new effort for advisers, according to Mr. Bernstein. The risk alert, he said, covered the basics.
“Nothing in there should be a surprise,” Mr. Bernstein said. “Don't panic, but get your ducks in a row.”
The SEC intends to continue trying to stop the next Madoff before he or she gets started.
“Anything that's not in compliance with that [custody] rule means there's a weakness in the [compliance] system, and you could have fraud arise,” Mr. di Florio said. “We'll keep it a top priority on our exam plan.”
