Advisor groups relieved: no surprise audits for RIAs with third-party custodians

December 16, 2009 — 9:43 PM UTC by Elizabeth MacBride

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The SEC today passed new regulations for asset custody, in large part in response to the Madoff scandal. The new rules will make it more likely that a misappropriation of funds by an advisor will be discovered.

To the relief of many advisor groups, the SEC will not require advisors who deduct fees and who custody their assets with third parties to submit to surprise audits. The SEC released the following chart that explains in more detail the new provisions.

To fulfill the surprise audit requirement, advisors will have to engage an independent public accountant to conduct the audit. The custody controls review must be completed by an accountant registered by the Public Company Accounting Oversight Board.

The Arrangement Surprise Exam Custody Controls Review Concern
The client assets are in the physical custody of the adviser. Yes Yes There is a heightened risk that the adviser could misappropriate assets since there is no separate custodian.
The client assets are in the custody of a custodian that is affiliated with the adviser and not operationally independent. Yes Yes There is a heightened risk that the adviser could misappropriate assets because of its affiliation with the custodian.
The client assets are in the custody of a qualified custodian that is affiliated with the adviser but operationally independent because the affiliate and adviser operate as distinct entities with no overlap of personnel, office space or common supervision. No Yes If the adviser does not have access to the client’s assets, then a surprise exam is less meaningful, but a check on the affiliated custodian’s custody controls will focus on the effectiveness of custody protections.
The assets are in the custody of an independent, third party custodian, but the adviser has authority to withdraw client funds – such as by a power of attorney. Yes No The ability to withdraw client assets, heightens the risk that an adviser could misappropriate those assets and go undetected, so the annual surprise exam will serve to verify client assets.
The assets are in the custody of an independent, third party custodian and the adviser either has no control over the funds or merely has the authority to withdraw agreed-upon fees. No No There is no indication at this time that this type of arrangement has resulted in fraud that would warrant additional safeguards.

The decision of the SEC to back down on subjecting RIAs to surprise audits if assets are in the custody of an independent, third party custodian shows that it was not prepared to handle the backlash, according to Ross Albert, partner with Morris, Manning & Martin, which performs securities law from Atlanta.

“They have chits and political capital to play like anybody else and this was a battle they chose to avoid,” he says. “They want to keep their powder dry for other things higher on their wish list.”

Indeed, had the SEC pressed for surprise audits, it would have been like declaring war on RIAs, according to Zachary Gronich, president of New York-based RIA-In-A-Box, which helps advisors with compliance matters.

'I’d be nuclear’

“It’s a good idea if you can pull it off,” he says. “But from a practical standpoint, it’s darn near impossible. If I were an RIA, I’d be nuclear.”

The biggest problem is that the surprise audits were going to cost anywhere from $3,000 to $9,000 because they take up about two days of a CPA’s time. RIAs were going to be furious if the costs were foisted onto them.

Yet another issue was that surprise audits have an arch-aggression ring to them that the SEC is hoping to avoid.

“I have sympathy for the agency,” Albert says. “They are also blamed for being overzealous” at the same time as they are being blamed for not having been zealous enough regarding Bernie Madoff.

The bottom line is that the SEC acted in a responsible fashion, according to Ron Rhoades, director of research for Florida-based Joseph Capital Management.

“I think the SEC, overall, took a very balanced and well-reasoned approach to enhancing protections for the clients of registered investment advisers, including hedge funds,” he says. “It was noted several times by various Commissioners and SEC Division of Investment Management staff that the comment letters submitted by RIAs provided important, and constructive, feedback to the policymakers. However, this “Madoff Fix” has not, as Commissioner Aguilar correctly noted, addressed the problem of fraud in broker-dealer firms — which is what happened with Madoff, for nearly two decades, before he even registered as an RIA in 2006. I am concerned that Commissioner Aguilar’s call for tighter review of broker-dealer safeguards – that such a review be a “high priority” for the SEC and urgently addressed – may go unheeded.”

He adds: “As did other organizations, NAPFA pointed in its comment letter to the SEC that the surprise inspection requirement imposition, as to firms which deducted fees from client accounts, has never been a source of fraud..”


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RIA in a Box
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Bill Winterberg said:

December 17, 2009 — 3:11 PM UTC

Thanks for the update and for posting the “custody matrix” for reference. I’m sending my subscribers over here to RIABiz to get these details: <a href="http://fppad.com/2009/12/17/surprise-audit-provision-dropped-from-new-sec-custody-regulations/">Surprise Audit Provision Dropped From New SEC Custody Regulations</a>

Bill @ <a href="http://fppad.com">FPPad.com</a>

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wanderson said:

December 17, 2009 — 9:12 PM UTC

Anybody have any ideas how this limited partnerships that hold partnership units in venture capital funds (ie. consolditaing partnerships).


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