Surprise exams and reviews by third party accountants: These are the new measures the SEC proposed on Thursday to combat ponzi schemes like the one Bernie Madoff pulled off last December. Ponzi schemes have been piling up over the past several months. In fact, the SEC has taken more than two dozen enforcement actions involving ponzi schemes since January of this year, according to the regulator. The five commissioners voted unanimously in favor of the rule proposal.
The new rules would apply to the 9,600 SEC-registered investment advisers who custody client assets—this means that they maintain discretionary authority to withdraw client funds. Only a few hundred of these RIAs also act as the broker/dealer for those assets, physically holding them in house, or through an affiliate. It is the latter arrangement that allowed Madoff to pull off his giant swindle, in part. Because he was the custodian as well as the investment adviser, he was able to have direct access to their funds and to falsify their monthly account statements.
In a statement, SEC Chairman Mary Shapiro said the proposed rules “would effectively require that client assets be maintained with a qualified custodian independent of the adviser.” The rules would not outright require that investment advisers use a third-party custodian. But they would make physically custodying assets in house, or through an affiliate, more expensive and cumbersome.
Under the proposed rules, investment advisers who have discretion over client assets would be required to hire an independent public accountant to conduct annual surprise exams. These exams would aim to verify that client assets do, in fact, exist, and accountants would be required to inform the SEC if those assets were not where they were supposed to be. A second measure would require investment advisers who directly custody client assets in house, or through an affiliate, to hire a third party (PCABOB-registered) accountant to prepare a written review of the firm’s custodial controls, known as an SAS-70 report. “The status report is rather rigorous,” says Bob Plaze, Associate Director for Regulation of the Division of Investment Management at the SEC.
At least one securities attorney doubted the measures would do much to stop crooks from being crooks or to uncover fraud more effectively. “Had the SEC and any other government or self regulatory agency done investigation 101, they would have seen it before people lost their life savings,” said David Robbins, partner in the New York City law firm of Kaufmann Gildin Robbins & Oppenheim, of Madoff ‘s scam. As Special Deputy Attorney General of New York in the 1970s, Robbins was responsible for the civil and criminal prosecution of securities fraud cases. “When we prosecuted and investigated securities firms, the first thing you would do is check the clearing firm records,” he says. The other thing regulators have to do is educate consumers, he says. “There will always be ponzi schemes because that’s human nature.”