The Securities and Exchange Commission will issue a rule proposal as early as this week that would lead to surprise audits of investment advisory firms that held custody of their clients' assets.
Indeed, the SEC will issue “a series of post-Madoff regulatory reforms” over the next several weeks, SEC Chairman Mary Schapiro told the Mutual Fund Directors Forum's annual policy conference in Washington last Tuesday.
The SEC is “trying to leverage third-party resources” in overseeing advisers who hold custody over assets, she said.
In other words, the commission will likely rely on outside accounting firms that are regulated by the Public Company Accounting Oversight Board to verify that assets held by advisory firms exist and that customers are receiving truthful reports about the performance of their funds, Ms. Schapiro said.
One of the problems identified in the $50 billion Ponzi scheme perpetrated by Bernard L. Madoff Investment Securities LLC was that a small accounting firm, which was not regulated by the Washington-based PCAOB, was responsible for auditing the New York-based investment adviser.
“I expect they will propose that investment advisers with custody of assets undergo a surprise audit focused on confirming safekeeping of those assets,” said Douglas Henderson, managing director of advisory services at KPMG LLP in New York.
He is head of the securities segment of KPMG's regulatory practice, which provides consulting on regulatory compliance for investment advisory firms, broker-dealers and investment companies.
The
Financial Industry Regulatory Authority Inc. of New York and Washington requires that broker-dealers that hold client assets in custody to have in place internal supervisory controls as well as independent testing of those controls, Mr. Henderson said. But there is no requirement that independent public accounting firms conduct audits to verify the firms' assets under custody.
What's more, there is no provision allowing for surprise audits.
To be sure, the vast majority of investment advisory firms do not hold custody of assets.
“It is generally not considered a best practice,” said Neil Simon, vice president of government relations for the Investment Adviser Association in Washington.
Only about 1,000 advisory firms out of more than 11,000 SEC-registered firms hold custody of their clients' assets, according to John Coffee, a professor at Columbia University School of Law in New York.
“They're all vulnerable” to abuse, he said.
While requiring surprise audits by accounting firms regulated by the PCAOB would be an improvement, it would not put an end to fraud entirely, Mr. Coffee said.
“Auditors don't always catch everything,” he said. “The most obvious reform is to require the investment adviser to use an independent custodian.”
It's unclear whether any proposal issued by the SEC would apply to investment advisory firms that held assets in custody through affiliated broker-dealers.
“The brokerage industry is fighting the idea of giving up custody of assets, because they would lose the fees they now earn for custodial services,” Mr. Coffee said.
In addition to independent surprise audits, the SEC is likely to require senior officers of advisory firms to certify the controls they have in place involving the custody of assets, Mr. Henderson said.
E-mail Sara Hansard at [email protected].
