Custody battles

After months of anticipation, the US Securities and Exchange Commission has released changes to the Investment Advisers Act of 1940 that will result in additional compliance costs for some registered investment advisers. However, it appears that industry push back convinced the SEC to water down some of the more burdensome requirements.

The SEC proposed the new rules last year in response to recent scandals involving investment advisers and broker dealers like Bernie Madoff. The agency contends that creating a stricter custody regime would better protect clients’ assets from misuse and help the SEC to uncover fraud earlier. The SEC has also estimated that additional compliance costs would come to around $8,000 for RIAs, although some industry estimates have put that total higher.

According to a memo by Paul, Weiss, Rifkind, Wharton & Garrison, the new rules require RIAs that have “custody” of client assets to undergo an annual surprise examination by an independent public accountant to verify client assets. The accountant must also notify the SEC within one business day of any material discrepancies found during the examination, file a Form ADV-E within 120 days of the examination’s start date, and file the form within four days if the accountant resigns or is dismissed.

The rules also require such advisers to have a reasonable belief that a qualified custodian who is maintaining clients’ assets is sending account statements directly to the advisory clients. If the client assets are maintained by an independent custodian, the RIA must obtain an annual report of the internal controls in place at the custodian, to be prepared by an independent public accountant that is registered with the Public Company Accounting Oversight Board (PCAOB). Those reports may be in the form of SAS 70 audits, which can be thorough and expensive.

Since announcing the proposed rules, the SEC heard from a number of industry players who worried that the annual surprise audits, disclosure requirements and more extensive record-keeping rules would impose extremely onerous burdens and potentially put small firms out of business. One commenter on the SEC website said surprise audits would unreasonably affect “solo” practitioners, and that having to pay for one would bankrupt his business, while another said annual or third-party audits of compliance programs would be an unnecessary cost with little benefit to investors.

Such feedback may have caused the SEC to include some important exceptions to the annual surprise examination requirement in the final version of the rules. According to Paul Weiss, advisers to pooled investment vehicles that obtain an annual PCAOB-approved audit and distribute financial statements to investors are exempt from the requirement.

Also exempt are advisers who only have custody of client assets to the extent that they are authorised to deduct advisory fees directly from a client’s custodial account. Finally, an adviser is not subject to the requirement if it both maintains custody of client assets solely because of custody by a related person, and also if it is operationally independent from a related person.

Such exceptions likely mean that the surprise exams should only affect the nearly 2,000 current SEC-registered advisers who provide in-house custody of securities. But as proposed regulations working their way through Congress could significantly increase the number of firms who will have to register in the future, those who wish to avoid the additional disclosure and audit costs should plan to update their custody arrangements and/or compliance procedures, including possibly making it explicit that the adviser does not have authority over client assets held by a custodian.