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A Call to Arms

A new SEC proposal could take a dent out of advisors' bottom lines.

Helen Modly, 07/16/2009

Registered investment advisors take note: The SEC has decided that you should pay for its past failures. No, it isn't going to send you a bill directly. Instead it is proposing a new set of regulations that will require 9,575 registered investment advisors to spend an estimated $8,100 each for a surprise annual audit. The SEC also estimates that the internal cost to these advisers in terms of employee time and resources to cooperate with these annual audits will be about $1,150 annually. Let's do the math: 9,575 advisers spending $8,100 each for a CPA audit plus $1,150 in internal costs equals $77,000,000 transferring from advisors' bottom line to the bottom line of the CPA firms, plus an additional $11,000,000 hit to the bottom line of our industry.

For What?
According the 95-page document outlining the new proposal, this almost $90 million dollar rule change is to protect investors from unscrupulous advisors who deduct more than the agreed-upon fee from their clients' accounts. In 2003, the SEC amended the custody rule, 206(4)-2, and eliminated the surprise audit requirement for advisors who had a "reasonable belief" that a qualified custodian was providing an account statement directly to clients.

"We believed that direct delivery of account statements by qualified custodians would provide clients confidence that any erroneous or unauthorized transactions would be reflected and, as a result, would be sufficient to deter advisers from fraudulent activities.

We have decided to revisit the 2003 rulemaking in light of the significant enforcement actions we have recently brought alleging misappropriate of client assets. We believe that a surprise examination by an independent public accountant would provide 'another set of eyes' on client assets, and thus additional protection against their misuse."

So, now Mary Schapiro, the head of the SEC, is convinced that the auditing of thousands of advisors, whose only incident of custody is that they deduct their fees directly from their client accounts, would protect investors from advisor fraud.

Oh Really?
First of all, let's not forget that Madoff, Stanford, and the other recent crooks either served directly as their own custodian/broker-dealer or used a related broker-dealer (or, as in Stanford's case, a related bank) as custodian for the client assets that they misappropriated. As such, they were subject to routine inspection and regulation by the deceptively named Financial Industry Regulatory Authority, under Schapiro's watch. In fact, Madoff's broker-dealer was inspected every two years by FINRA/NASD since 1960. As RIAs with custody of client assets, they were also subject to this surprise audit requirement by a public accountant. In each case, they managed to find a CPA who was willing to look the other way.

Never mind that the client accounts of these 9,575 advisors who would be affected by this rule change are actually held by a qualified custodian. Never mind that all custodian/broker-dealers are already subject to an annual audit of their operations including verification of client assets. Never mind that virtually all qualified custodians send statements directly to clients at least quarterly, and usually monthly. Never mind that in today's age almost all clients of qualified custodians have 24/7 online access to their accounts, including the ability to view any fee deduction. In reality, clients of advisors who utilize an independent, qualified custodian have the ability to detect a fraudulent transaction within hours or at most within three months of the act. Why would an annual surprise examination of an advisor by a CPA to verify client assets which are not held by the advisor increase investor protection?

The Trickle-Down Issue
It is important for consumers to realize that not only advisors are going to be affected. This rule will almost certainly cause many firms to increase the fees they charge clients to offset at least a portion of this $90 million political response to a non-problem. Instead of meaningful regulations that could actually impose a higher standard of behavior upon advisors, the SEC proposes to increase the cost to consumers for a highly questionable improvement in protection.

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