Will SEC Be Able To Enforce Proposed Custody Rules?
TowerGroup: SEC "outmatched" by number of RIAs, funds
June 1, 2009
Even as the Securities and Exchange Commission proposes new rules to strengthen oversight of registered investment advisers (RIAs), experts warn that the agency may not be able to enforce them due to inadequate staff and budget resources.
With 425 examiners to cover 11,300 RIAs along with 8,000 mutual funds, the SEC "has proven to be outmatched by their sheer numbers," says Matthew Bienfang, senior research director at Needham, Mass.-based TowerGroup and author of "Broker vs. Adviser Regulation," a report released by TowerGroup last month.
Still, the SEC has not been shy about touting its new proposals as measures that "substantially increase protections for investors" who trust their money to investment advisers. The proposals, approved by the agency on May 14, aim to tighten reporting requirements for investment advisers who have legal custody of clients' assets.
They mandate an annual surprise exam for all registered investment advisers who have the authority to withdraw securities or funds on behalf of their clients from institutions which have physical custody of the assets. The exam would apply to about 9,600 advisers, according to SEC Chairman Mary Schapiro.
The rules also require all physical custodians to send account statements directly to the owners of the assets, rather than having the reports go through the investment adviser. A third proposal requires advisers with actual physical custody to obtain a written report from an accounting firm attesting to its controls. This custody control review would have to be performed by an accountant registered with and inspected by the Public Company Accounting Oversight Board (PCAOB).
"We are taking this action in response to major investment scams," said chairman Schapiro before the SEC voted 5-0 to propose the rules. "They will greatly enhance the independent checks'' of the controls instituted by advisers.
Even so, Schapiro has acknowledged that the SEC as presently staffed and funded may not be up to assuming additional regulatory responsibilities. In March, she was quoted in an interview with The Wall Street Journal as saying that the SEC needs more resources to take on hedge fund oversight, without quantifying how much.
The issue with custody is that unlike banks or broker-dealers, RIAs generally do not have physical custody of their clients' funds or securities. Instead, client assets are maintained with a bank or broker-dealer. But the adviser may still be deemed to have custody because it has the authority to withdraw client funds from the custodian. Or, the broker-dealer custodian may be affiliated with the adviser, as was the case with Bernard Madoff, giving the adviser indirect access to client funds.
In addition to resource problems at the SEC, critics also charge that inadequate oversight by Finra, the self-regulator for broker-dealers, allowed Madoff's massive Ponzi scheme to go undetected for decades. "The issue around Madoff is that Finra could have examined the broker-dealer," says Bienfang. "Madoff was printing trades that were never executed. Finra ought to have found it."
While the new SEC rules do not address problems at Finra, they do impact broker-dealers who are custodians by requiring all custodians holding adviser assets to directly deliver statements to clients rather than going through the adviser.
Two Hats
Complicating any reform is the fact that broker-dealers are required to follow a rules-based regulatory regime. This involves considerable compliance costs (table), amounting to $5,000 or more a year per representative of a full-service firm. RIAs, who subscribe to a fiduciary role in dealing with clients, operate under fewer rules which come at a lower cost of compliance. Neil Simon, a spokesman for the Investment Adviser Association, said he did not have any hard data on how much RIAs spend on compliance.
