How the SEC’s new rules will protect investors and impact advisers Featured

8:00pm EDT April 25, 2010

New amended custody rules implemented by the SEC in March mainly impact those in the investment arena but could have an impact on others as well. The amendments to the SEC’s Custody Rule under the Investment Advisors Act of 1940 were designed to provide additional investor safeguards by requiring financial advisers with custody of client funds to maintain those assets with broker-dealers, banks or other qualified custodians, says Brian Finnegan, a partner with Burr Pilger Mayer.

“This is a sign of things to come, with more SEC and other government regulations on the horizon,” says Finnegan. “SEC Chairman Mary Schapiro’s focus is on pursuing an aggressive investor-focused agenda, and there are items being considered in Congress that would give the commission more funding to protect investors and step up oversight of investment advisers.”

Smart Business spoke with Finnegan about how the landscape is changing and how the new amendments will affect both investors and investment advisers.

How have the rules changed over the years?

Since 1966, registered investment advisers and others paid to manage money had been required to undergo a surprise exam by an independent accountant each year. In 2003, the SEC decided that if a qualified custodian was maintaining clients’ assets, there was no need for surprise exams.

Following the Madoff scandal and other high-profile Ponzi schemes and theft of client assets, the SEC decided that wasn’t a good idea. So, in 2009, it proposed custody rule amendments, which became effective March 12, 2010.

What do the new amendments require?

  • A qualified custodian must maintain client assets, and each client’s assets and securities must be held in a separate account (or in an account containing only client funds under the adviser’s name as agent).
  • Qualified custodians must send out account statements, and the registered adviser, after due inquiry, must have a reasonable belief that those statements are being sent.
  • An adviser must inform clients if he or she opens new accounts on their behalf.
  • Advisers who have custody of client assets must undergo an annual surprise examination by an independent public accountant to verify the existence of client funds. If the adviser has no control over the assets beyond deducting advisory fees from the account, that adviser is exempt from the surprise examination requirement.
  • Advisers of pooled investment vehicles are exempt from the surprise examination provided the underlying pooled fund undergoes an annual financial statement audit performed by a public accountant registered with and subject to inspection by the Public Company Accounting Oversight Board.
  • Advisers or related persons serving as qualified custodian must also receive an internal control report from an independent accountant.

What is the purpose of surprise examinations?

The bulk of the amended custody rule focuses on the reinstitution of surprise examinations for all registered investment advisers who are deemed to have custody of assets, and this is the piece that is causing heartburn in the investment advisory arena because it’s one of the costliest pieces of this reform.

Those who are using a qualified custodian and serve as a trustee or have general power of attorney over client assets are required to hire an independent accountant at least once a calendar year to perform a surprise examination. The bottom-line objective is to make sure that those client funds are where they are supposed to be and in the correct amount.

The accountant will obtain the records of the registered investment adviser and perform a sample inspection to confirm with the qualified custodian that what is said to be in the client accounts is what’s actually there. The accountant will also sample clients to confirm that any trades, liquidations, purchases and amounts transferred have been done with their knowledge and that the ending balance is what they believe to be proper.

How does this increase investor protection?

Previously, if you think of the Madoff case, the information that was provided to clients in terms of account balances was not accurate. Now, if an adviser tries to misappropriate client funds, these new rules would allow for a timely detection of such theft. Of course, the hope is that the new rules deter advisers from attempting any such wrongdoing.

In a nutshell, the new custody rules force advisers to utilize a qualified custodian, the qualified custodians send account statements directly to the adviser’s clients, and an independent accountant then separately confirms balances.

How does the amendment reduce the burden on advisers?

Previously, the advisers had to send out account statements to clients. The burden is reduced because the qualified custodian needs to do that now. All the adviser has to do, based on due inquiry, is have the belief that those account statements are being sent to his or her clients. If advisers also want to send account statements to clients, they can, but they need to clearly mark in the correspondence that the client should compare that document with the statements sent by the qualified custodian. That requirement is to prevent advisers from sending something that is fictitious.

It’s a difficult balance to strike between protecting investors and not creating onerous costs that drive advisers out of business. No investment adviser is going to say this is a bad thing, but there has to be a balance between what’s economically feasible and sustainable and how you protect investors.

Brian Finnegan is a partner with Burr Pilger Mayer. Reach him at (415) 288-6249 or