The Securities and Exchange Commission’s custody rule governing investment advisors’ custody of client assets imposes various requirements and, in turn, costs on investment advisors, who often need to hire independent accountants to conduct surprise examinations, according to a new report by the Government Accountability Office
To protect investors, the rule requires advisors that have custody to use qualified custodians (e.g., banks or broker-dealers) to hold client assets and have a reasonable basis for believing that the custodian sends account statements directly to clients. The rule took on urgency in the aftermath of Bernard Madoff’s Ponzi scheme, in which his office sent fraudulent statements for decades to his investment clients, who were cheated out of billions of dollars.
The SEC rule also requires advisors with custody, unless they qualify for an exception, to hire an independent public accountant to conduct annually a surprise examination to verify custody of client assets, the GAO noted. According to accountants whom the GAO interviewed for the report, examination cost depends on an adviser's number of clients under custody and other factors.
These factors vary widely across advisors that currently report undergoing surprise examinations: for example, their reported number of clients under custody ranged from 1 client to over 1 million clients as of April 2013. Thus, the cost of the examinations varies widely across the advisors, the GAO noted.
The rule also requires advisors maintaining client assets or using a qualified custodian that is a related person to obtain an internal control report to assess the suitability and effectiveness of controls in place. The cost of these reports varies across custodians based on their size and services.
The SEC provided an exception from the surprise examination requirement to, among others, advisors who were deemed to have custody solely because of their use of related but “operationally independent” custodians. According to the SEC, an advisor and custodian under common ownership but having operationally independent management pose relatively lower client custodial risks, because the misuse of client assets would tend to require collusion between the firms’ employees. To be considered operationally independent, an advisor and its related custodian must not be under common supervision, not share premises, and meet other conditions.
Approximately 2 percent of the SEC-registered advisors qualify for this exception for at least some of their clients. If the exception were eliminated, the cost of the surprise examination would vary across the advisors because the factors that affect examination cost vary widely across the advisors.
Investment advisors provide a wide range of services and collectively manage around $54 trillion in assets for around 24 million clients. Unlike banks and broker-dealers, investment advisers typically do not maintain physical custody of client assets. However, under federal securities regulations, advisors may be deemed to have custody because of their authority to access client assets, for example, by deducting advisory fees from a client account. High-profile fraud cases in recent years highlighted the risks faced by investors when an adviser has custody of their assets.
In response, the SEC amended its custody rule in 2009 to require a broader range of advisors to undergo annual surprise examinations by independent accountants. At the same time, the SEC provided relief from this requirement to certain advisers, including those deemed to have custody solely because of their use of related but “operationally independent” custodians.
The Dodd-Frank Wall Street Reform and Consumer Protection Act mandated the GAO to study the costs associated with the custody rule. This report describes the requirements of and costs associated with the custody rule and the SEC’s rationale for not requiring advisers using related but operationally independent custodians to undergo surprise examinations.
To address the objectives, the GAO reviewed federal securities laws and related rules, analyzed data on advisers, and met with the SEC, advisors, accounting firms, and industry and other associations.
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