Update: See the article FPA, NAPFA and IAA to fight SEC’s pop-quiz proposal from InvestmentNews.com where group officials say “that the proposal is misguided and would saddle advisers with unnecessary costs.”

It should be no surprise to financial advisers following the Madoff Ponzi scandal that the SEC recently issued proposed rule changes to custody requirements. The release, IA-2876 (click to view PDF from SEC.gov), addresses custody requirements of client funds and securities and is open for a 60-day comment period through July 28, 2009. Should the proposed rules be adopted, advisers may face additional compliance fees of $8,100 on average.

Surprise Examination Proposal

The SEC proposes that advisers with custody of client assets must undergo an annual surprise examination by an independent public accountant, regardless of whether or not assets are held by a qualified custodian. The premise behind the surprise examination requirement is to provide “another set of eyes” on client assets to prevent fraud and misappropriation of client funds by registered advisers.  Reports of theft and fraud by advisers have plagued the SEC since the Madoff scandal erupted in late 2008. So what does this mean for advisers meeting the custody definition?

Custody Defined

Custody of client funds is a topic that has been discussed before on FPPad.com. See my past posts linked below:

• Webinar to Discuss Risks of Custody and Client Credentials
• The Custody Conundrum at Advisor Perspectives
• Client Login and Custody Issues Covered by Financial Advisor Magazine

I’ll repost the definition of custody here for reference.  Under Rule 206(4)-2, an investment adviser has custody of client funds if it “holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.”

Advisers that meet the definition of having custody must adhere to additional regulations and requirements described in the rule (see my article The Custody Conundrum in Advisor Perspectives for all the requirements).

Advisers Subject to Custody Requirements

I’ve found that some advisers are under the false impression that custody requirements do not apply since they use a qualified custodian such as Schwab Institutional, Fidelity, or Pershing. Using a custodian alone does not avoid custody of client funds. If advisers withdraw advisory and/or management fees directly from client accounts, then the adviser is deemed to have custody of client funds.

Unless advisers are paid via other mechanisms such as credit card payments or by check, they have custody of the funds from which fees are debited. Note that if deducting fees is the only reason custody is triggered, the SEC allows advisers to check No in Item 9 of From ADV Part I.

Cost of Surprise Audits

Buried in the proposal is an analysis of estimated costs incurred by advisers who would be required to retain an independent public accountant to perform the surprise audit. The SEC estimates that over 9,500 registered advisers would pay an average of $8,100 in accounting fees.

Comment Period

If the only reason advisers have custody of funds is to debit management fees, should the SEC exempt them from the surprise examination requirement? Is the withdrawal of advisory fees less likely to be subject to abuse than full withdrawal authority? What do you think?

Advisers have two months to submit comments to the SEC regarding the proposed changes to existing custody requirements. Click here to open the form to submit comments on the SEC website.

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This entry was posted on Thursday, May 21st, 2009 at 1:55 pm and is filed under Practice Management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.