The US Securities and Exchange Commission is currently requesting feedback on a number of proposed amendments to the Investment Advisors Act of 1940 – specifically Rules 206(4) and 204-2, and Forms ADV and ADV-E. The changes would impose a number of burdens on RIAs, more of whom would be subject to annual surprise audits, disclosure requirements regarding assets under management and some client information, and more extensive record-keeping rules. The costs associated with these changes could put small firms out of business, commentators say.
The new rules, which the SEC says were spurred by several enforcement actions it has brought in recent months against “investment advisors and broker-dealers alleging fraudulent conduct, including misappropriation or other misuse of investor assets”, would create a stricter custody regime in order to better protect clients’ assets from misuse, and to uncover fraud earlier. The SEC estimates that if adopted in their current form, advisors would incur additional compliance fees of $8,100 annually.
- Advisors maintain clients’ assets in separate identifiable accounts with a qualified custodian, either by having a reasonable belief that a qualified custodian sends quarterly account statements directly to clients, OR by sending its own quarterly account statements to clients and undergoing an annual surprise audit.
- Advisors to pooled investment vehicles may have the pool audited annually and distribute the audited financials to investors in the pool within 120 days of the end of the pool’s fiscal year.
- All registered advisors must have a reasonable belief that a qualified custodian sends quarterly account statements AND must undergo annual surprise audits.
- Advisors are presumed to have custody over any clients’ assets that are maintained by the advisor’s “related persons” so long as the assets are in connection with advisory services.
- If the advisor or related person himself serves as the qualified custodian, the advisor must submit an annual internal control report which includes an opinion from an independent public accountant registered with the Public Accounting Oversight Board, and a description of the controls in place related to custodial services.
- Advisor and accountant must inform the SEC within one business day of finding any material discrepancies during an examination.
- Advisors must obtain a copy of an internal control report from its related person.
- Advisor must maintain the copy for five years from the end of the fiscal year in which the internal control report is finalised.
- Advisors must report on Schedule D of Form ADV each related person that is an investment advisor; advisors are permitted to report the names of related person broker-dealers.
- Advisors must report whether they or a related person have custody of client funds.
- Advisors are required to report on Schedule D all related persons who are broker dealers and identify which serve as qualified custodians of client funds.
- Advisors must also include on Schedule D the identity of the accountants who perform the audits and examinations and prepare internal control reports, the address, PCAOB registration and inspection status of those accountants, the type of work the accountant provides for the advisor, and whether the accountant’s report was unqualified.
- Advisors must report the dollar amount of client assets and the number of clients of which it has custody.
- Form must be filed within 30 days of the completion of an examination, along with a certificate confirming the accountant has completed the examination as well as describing the nature and extent of the examination.
- Forms must be filed within 120 days of the completion of an examination.
- If the accountant resigns or is dismissed, he must file the form within four business days. The form must include his name, address and contact information, and an explanation of any problems that contributed to his departure.
- The most controversial implication of the proposals is that investment advisers that do not maintain physical custody of client funds or securities but rather may have custody because they have the authority to obtain client assets, such as by deducting advisory fees, would now be required to undergo surprise audits. Most of the estimated additional compliance costs also stem from this requirement.
Industry professionals also objected to the overall tenor of the proposals, namely that many of the additional regulations would be unnecessary, or unlikely to stop those truly motivated to commit fraud.
“I think it may discourage people from starting a scheme like Madoff started – if you’ve got a real accounting firm looking at your books it’s obviously at inception going to be a lot harder to think that you could pull of a scheme like that,” says Howard Caro, a partner at law firm Hogan & Hartson. “All of that said, I think that really smart people that are motivated to commit fraud are always going to be able to get away with it, for some period of time at least.”
But he adds that if the SEC increases its manpower and its understanding of the industry, in addition to putting more rules on the books, it could more effectively cut down on fraud: “Beyond having a system in place like the SEC is trying to set up here, you have to have qualified people conducting the examinations, you have to have SEC staff with enough resources to conduct examinations and to know what to do with the information they get.”
The industry reacts
Some of the comments posted on the SEC website in response to these proposals are excerpted here:
“Your proposed rule regarding the payment of surprise audits will unreasonably affect ‘solo’ practitioners. Personally, I generate about $80,000 in annual fees and my profit is less than 10 percent of that. Requiring me to pay for surprise audits will bankrupt my business.” – Ricardo Ulivi, NAPFA
“The proposed rule does absolutely nothing to protect consumers. It serves only to create a barrier to entry to independent advisors, and to help return lost market share to the very firms who have historically done the most consumer harm.”
– John Hutchins, CEO, Comprehensive Planning Associates, CFP, AIF
“We feel early detection of theft or misallocation of funds will best be uncovered through audits of accounts, not through audits of compliance programs. There is certainly a benefit to evaluating an investment advisor’s compliance program, but SEC staff is best suited to carrying out that function. Annual or periodic third-party audits of compliance programs seems to be an unnecessary cost, with little or no enhancement of investor protection to justify the expense and business disruption.”
– Lorinda Roth, Compliance Officer, Syverson Strege Company
“In regards to the rule change for advisers collecting fees from accounts being subject to yearly audits, I feel this is a poor idea for many reasons. First, there are already checks and balances in place to protect clients from abuse. Broker-dealers or custodians can and do review the billings for appropriateness. Also, in the majority of cases, these accounts are held at a third-party custodian, who lists the deducted fees on monthly statements for account holders to review. Additionally, advisors who are able to deduct fees from client accounts need written authorization to make payments to anyone other than the client. There is a barrier in place to prevent abuse by the advisor which has worked well for decades. Overall, this rule would distort the meaning of the word “custody”. The ability of an advisor to deduct fees from an account does not give the advisor complete control of cash inside of the account. The third-party custodian acts as a gatekeeper to the advisor’s ability to pull funds from client accounts and thus adds a layer of protection for the client.”
– Arlen Olberding