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One-Man Think Tank: The SEC's custody examinations leave gaps big enough for Madoff to drive a bus through

How to reassure clients who are seeing Ponzi after Ponzi unveiled

Tuesday, July 27, 2010 – 1:57 AM by Ron Rhoades, Columnist
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Ron Rhoades: Many RIAs rightly question the utility of limited inspections by regulators.

Ron’s note: In my prior column One-Man Think Tank: Six steps to avoid getting sued and having your reputation destroyed in the bargain, I explored ways to mitigate the risk to an RIA firm related to the filing of a lawsuit by a client. In this second part of this series, I explore the reputational risks posed to RIA firms by the recent, and seemingly ongoing, unveiling of Ponzi schemes and other frauds in securities firms.

Clients entrust registered investment advisers with their wealth – and with it, their financial futures, hopes and dreams. Without trust in the safety of their funds, Americans would likely confine the placement of their accumulated financial assets to the perceived safety of government-insured bank accounts. Such attitudes prevail in many countries, resulting in far less access to capital by entrepreneurs and established commercial enterprises. Reluctance to entrust money to entities outside the government leads to stagnant national economic growth.

One of the prerequisites that gives clients the confidence to commit their monies to the stock or bond markets is their belief that, while the government cannot prevent all fraud from occurring, government oversight can and will act responsibly to detect fraud early. Consumers seek to have government inspections of securities firms frequently occur, in order that small schemes do not become bigger ones, and in order that potential fraudsters are at least somewhat deterred from the pursuit of any bad motivations.

What the SEC and FINRA didn’t do in the Madoff and Starr cases

Stated differently, Americans rightfully expect that government regulators engage in a robust VERIFICATION process, to ensure that entrusted financial assets are actually present in the accounts established. What is so noteworthy about the recent Madoff, Stanford, and other cases, is the utter failure by government regulators to undertake the process of verification, even when substantial information existed alerting officials to the prospect of actual fraud. Regardless of whether FINRA or the SEC – or some other regulator – is to blame, the government’s repeated failures to verify have shaken the confidence of many American investors.

Despite recent (and erroneous, to a large degree) assertions by FINRA that the investment adviser community resists proper oversight, most investment advisers with whom I have spoken desire both a robust and frequent inspection of the activities of RIA firms. These professionals know that each time a fraud goes undetected for long periods, and then is finally unveiled only after much damage occurs, investor confidence in the entire securities industry is shaken. Hence, these knowledgeable advisers desire a much more frequent, and thorough, examination of client accounts by the SEC and/or by state regulators.

Of course, many independent RIA firms don’t accept “custody” of clients’ accounts, save for the deduction of fees from client accounts. Those firms that do possess custody, as such term has been interpreted by the SEC staff, remain fearful not of the examination process itself (involving PCAOB-certified CPAs), but of the utter failure of such exams to meaningfully provide protection to client assets. And they resent the cost of limited exams which are perceived to offer very little real benefit in terms of protecting client assets.

As an example of the inadequacy of limited purpose custody examinations, suppose an RIA firm possesses “custody” over the accounts of some clients, but not the accounts of other clients. What type of inspection results? As the inspection occurs, the RIA firm informs the auditor of the account numbers for which it has custody, and the auditor does a “random sampling” of just these accounts. But what if the RIA firm omits to tell the auditor of just those accounts from which the advisor has embezzled funds? How would fraud be detected then?

Regulators ought to look in the last filing cabinet

Many RIAs seriously question the utility of limited inspections. Indeed, in my conversations with several securities examiners, they relate stories of where fraud was uncovered only after they insisted upon inspecting records held in the last file cabinet in some small back room of a securities firm. It is well known that examinations to verify that client investment assets actually exist must be highly robust inspections of all of the activities of a firm. Inspection must occur of every nook and cranny of a firm’s offices, with steps taken to crosscheck accounts referenced in client communications (emails, etc.) against custodial records.

Until federal and state regulators gain the resources to undertake robust and frequent inspections, what can RIA firms do to ensure that assets are not misappropriated from client accounts, thereby causing enormous danger to the firm’s reputation?

Since regulators don’t look in the last filing cabinet, here’s what you should do

1. First and foremost, establish procedures for compliance staff to monitor (and when necessary verify) all account withdrawals (over a particular amount) and transfers.

2. Run periodic background checks on all employees, including credit histories.

3. Routinely emphasize to clients that while the firm possesses a robust internal account verification system, each client should review their custodial statements each month to ascertain if any transactions occurred that may be suspect. Provide clients with the direct phone number of a compliance officer should questions arise.

4. Closely monitor all relationships where the client is elderly or may possess diminished capacity, by means of periodical reviews of the entire file.

5. Let employees know that their activities are scrutinized, but don’t specify how (lest a dishonest employee devises a way to get around such scrutiny).

Of course, many other measures can be implemented within a firm to verify asset custody and deter and/or prevent fraud; discuss such measures with your compliance consultant.

Lastly, RIAs should both individually and collectively advocate for more frequent, robust, and yet sensible inspections by government regulators – and for such regulators to have the resources required to conduct same. Let’s inform examiners of ways to better conduct meaningful examinations, and let SEC Commissioners and senior staff know that limited purpose exams are unlikely to detect actual fraud.

Restoring the confidence of investors in the verification processes expected of regulators will take action, and time. In the end, however, all investment advisers will benefit. And, just as important, capital will continue to flow to our capital markets, thereby providing the fuel for much-needed economic activity.

Ron A. Rhoades, JD, CFP® serves as Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a registered investment adviser with offices in New York, North Carolina, Georgia and Florida. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.



July 29, 2010 — 5:23 PM

RE: #2 – Madoff had perfect credit histories, as do nearly all white collar criminals. Studies show zero correlation between credit history and ethical job performance. The big three credit reporting agencies have admitted, albeit very quietly, that no such correlation exists. These firms simply wish to perpetuate the assumption in order to boost profits from employer ordered credit reports. In fact, the congressional bill which would ban employer credit checks has been stalled in the House finance committee due to the political influence they have over the top committee members who collected the most contributions from the big three.

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