|News Analysis: The Real Story Behind The SEC Warning That It Has Found “Widespread” Violations By RIAs Of The Custody Rule|
|Tuesday, March 05, 2013 19:32|
The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations today warned RIAs that it is finding “widespread” non-compliance with the custody rule under the Investment Advisers Act of 1940. But the real story is that the SEC is flexing its muscle and enforcing the custody rule because it never paid much attnetion to this issue before.
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“The NEP (National Examination Program) reviewed recent examinations that contained significant deficiencies,” says the alert issued by OCIE. “Approximately one-third of them (over 140) included custody related issues.”
Simultaneous to issuing the warning to RIAs, the SEC issued an “investor bulletin” explaining the custody rule to consumers.
The deficiencies NEP staff are finding can be grouped into four categories:
As a reporter who has covered the RIA business for over 25 years, here’s my assessment of what’s happening.
About 90% or 95% of RIAs do not take custody of client assets. They outsource the job to escape the onerous requirements of serving as a custodian. If an RIA does not outsource the job of the custodian, the RIA must comply with rules that protect investors, costing them a lot of money and are an enormous hassle.
Requirements Of RIAs Taking Custody
In addition, RIAs taking custody of client assets and holding the assets at a qualified custodian must hire an independent accountant to conduct a surprise exam of the custodial arrangement at least annually to verify that client assets are indeed where they’re supposed to be.
Moreover, if the custodian is related to the RIA, the accounting firm that conducts your surprise audit must be registered with the Public Accounting Oversight Board, an accounting industry self-regulatory organization overseeing CPAs that audits public companies, and the RIA also must annually get a report from its auditor saying controls are in place to verify client assets are accounted for properly.
RIAs acting as a general partner in pool of client assets face even stiffer requirements, including the expensive task of annually providing clients with an audited financial statement. Obtaining an independent audit excuses an RIA from the surprise audit and QC statement requirements, however.
The Accidental Custodian
Apparently, however, RIAs are taking custody of client assets inadvertently. They’re accidental custodians, guilty of being sloppy or ignorant of the custody rule requirements. How can an RIA be an accidental custodian? Let’s count the ways.
1. Your client gives you the password and user ID for his 401(k) or other accounts. It’s not uncommon for an RIA to ask clients for their passwords to their 401(k)s and other accounts. RIAs want to manage the 401(k) assets one day and have an incentive to monitor held away assets. But if you gain access to an online account where you can trade, you’re a custodian of those assets.
These investment advisors are making a deliberate decision to be dealmakers in private ventures or are essentially running their own private mutual funds. Because the activities of these RIAs are far more opaque than the business of the vast majority of RIAs, the custody rule imposes special requirements on them. These RIAs must either outsource to a qualified custodian or hire an independent CPA firm to audit the pooled assets or partnership deals and provide a financial statement opining on the condition of each investment entity.
The Real Story Behind Today’s SEC Alert
While it is obvious that holding a client’s physical assets—stock certificates, bonds, deeds, partnership agreements, and other valuables—would make you a custodian and trigger the custody and all its requirements, the less obvious ways enumerated above can make an RIA a custodian accidentally, and that’s where RIAs are probably falling short.
But the real story here is that the SEC is proactively doing something about the custody rule. The SEC for as long as I’ve been covering this business has always tolerated widespread deficiencies in RIA compliance with the custody rule.
Fraud by RIAs was probably not enough of a problem to merit enforcement of the custody rule. The SEC had bigger fish to fry. That all changed after the market crash of 2008 revealed a small number of RIAs as Ponzi schemes, including the Bernie Madoff fraud.
The custody rule has been in place since 1962, according to the SEC’s alert today. While the details of the rule have been updated, including some changes made as recently as 2010, the rule has been on the books for over 50 years. The real story is that the SEC is actually doing something to enforce it now.
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