New rules aimed at preventing registered investment advisors from pulling off ponzi schemes take effect Friday. Among other things, RIAs firms that hold clients assets in custody will be required to undergo annual surprise audits, conducted by independent public accountants.
For advisors who dislike regulation, there’s some good news; the industry successfully lobbied the Securities and Exchange Commission to exclude a broad group of RIAs—those who exert marginal control over clients’ custodied assets—from having to undergo the annual audits.
But then, surprise audits appear destined to become a bigger part of the regulatory landscape. The SEC put broker-dealers on notice that they may face audit requirements similar to those of RIAs if they custody customer assets. In its amendment, it called the new RIA rules “a first step” in improving custody protection, “with consideration of additional enhancement of the rules governing custody of customer assets by broker-dealers to follow.”
In the wake of the scandals involving Bernard Madoff and other investment managers, the SEC in December agreed to amend the Investment Advisers Act of 1940 to make it more difficult for firms that custody client assets to abuse those assets.
The independent accountants who audit firms will be required to verify that the assets are, in fact, being held at the firm and to report on internal controls related to the custody of those assets. Under the new rules, RIAs will also be required to have any custodians that maintain client funds send account statements directly to the client. And they will be required to amend their forms ADV to allow advisors to report on their custodial arrangements to the SEC.
Firms must have their first surprise audit by Dec. 31, 2010. “Obviously, this rule was on the fast track,” says Valerie Baruch, assistant general counsel of the Investment Advisor Association. “It was proposed last May and adopted the same year, which is quite fast.”
It didn’t sit well with the industry when it was first unveiled. The SEC received 1,300 comments from advisors and industry representatives, most of them critical. One particular point of contention involved advisors whose custody of client assets is solely related to withdrawing their fees from the accounts. The SEC agreed to exclude that group of advisors from the new auditing requirement.
It was a big win for the industry; coupled with other SEC changes to the original rule amendment, it reduced the number of advisors who would be affected by surprise audits from 9,600 to less than 1,900, the SEC estimates. Cost estimates for the surprise audits varied widely between the SEC and the industry, and within the industry itself. The SEC estimated that about 1,500 of the affected advisors will see annual costs of $10,000 to $20,000, while the remaining 400 firms, which are much larger in size, can expect bills of around $125,000. In contrast, SIFMA last summer estimated that the cost of audits could range from $8,000 to $275,000, depending on the size of the advisor.
The final rules “struck a fair balance between investor protection and compliance burdens on investor advisor firms,” says David T. Bellaire, general counsel and director of government affairs for the Financial Services Institute. But industry groups are watching how the regulations will play out this year. “There’s a lot of elements to it,” Baruch says. “There are tons of questions.” The SEC has posted answers to questions it has received on its Web site.
“We acknowledge that no set of regulatory requirements we could adopt will prevent all fraudulent activities by advisers or custodians,” the SEC says. “We believe, however, that this rule, together with our examination program’s increased focus on the safekeeping of client assets, will help deter fraudulent conduct and increase the likelihood that fraudulent conduct will be detected earlier so that client losses will be minimized.”