June 30, 2009
I have been an SEC RIA since January of 2004, and also a member of FPA since the early 1990’s. I had been a Registered Representative with two broker/dealers from 1982 to 2004. I have never had a complaint, sanction or even an unhappy letter from a client. I have undergone yearly audits up until I became an RIA, and have never been found to have any problems.
I realize that the Madoff scandal has changed our world forever, because the public and political reactions to his scheme have been well-publicized, and because some of the blame was placed on the SEC’s allegedly lax audit and oversight of his firm. I passed my first audit (shortly before Madoff’s scandal broke) with just a few clerical infractions, but the two examiners spent enough time with me that they would have found anything of substance – if there had been any.
However, I feel strongly that the proposed change to require a surprise audit of all my discretionary accounts - solely because I have the ability to deduct my advisory fee from their accounts – is way beyond necessary and is severe overkill. I suspect that this proposal is designed primarily to show the public and Congress that you are “doing something” to stop future Madoffs, to deflect criticism of the SEC, and only incidentally because anyone actually thinks extra audits will catch any wrongdoing.
If I had the ability to disburse funds to third parties, or to pay a client’s personal bills, or otherwise have withdrawal rights to myself or others (beyond withdrawing my fee) I might see where an audit might have some legitimacy. In fact, isn’t that exactly what Madoff did – disburse funds to himself, family, and other parties for his personal enjoyment and enrichment? But I haven’t seen anything that indicated that his taking management fees had any bearing on the scandal. His main problem was that he was a self-custodian, able to manufacture false statements that covered his wrongdoings.
In your release IA-2876, you have two requirements: "notice to client", and "due inquiry requirement". I’d be amazed if less than 99% of advisors who hold assets with 3rd party custodians don’t already satisfy these – I certainly do, and (if I were just a citizen investor) I wouldn’t dream of becoming a client of someone who didn’t.
The SEC estimates that it might cost $8,100 annually (on average) to perform this surprise audit. In my case, especially after the market damage of this past year reduced my gross income, my net income will not support this cost. That’s more than I pay for my commercial office space, and more than I pay for outside accounting work. If the SEC insists on this, I will be forced to sell my business – at a sharp loss due to market values of practices being sharply reduced by the market drop.
My recent SEC audit was performed by two examiners, who were physically in my office 8 hours per day for two full weeks. In addition to those 80 hours, I worked another 20-30 hours each week digging up exhibits and answering their questions. I had ZERO time to watch the market or respond to my clients’ needs. To make it worse, my audit was during the first two weeks of September 2008 – the two worst weeks the market has experienced in history. My primary job is to handle client’s needs and concerns – and I was not able to do so in their most urgent time of need. If I have to undergo yearly surprise audits by CPAs, that will further reduce the time I have available to service clients.
Has the SEC considered where the huge numbers of CPA auditors are going to come from? If there are ~10,000 RIAs who deduct fees and are therefore subject to this proposed audit , that’s many thousands of CPA’s that have to be trained and tested to become PCOAB-registered.
As an alternative to your proposal, I propose the following as being more effective and less costly: Apparently my firm was considered "low-risk", as I was in business for almost 4 years before my first audit. The examiners indicated I would probably still be considered "low-risk" and probably not face another audit for several years. As a Registered Rep running my own OSJ for many years before forming my RIA, I expected yearly audits by my broker/dealer, albeit not of the depth I experienced from the SEC auditors. I would support a larger examination budget for the SEC, so you could hire more trained agents to perform more frequent audits.
As a second solution, I strongly suggest that only RIAs who do NOT have outside custodians be forced to undergo these audits – I suspect these are where you’ll find the most infractions.
As a third solution, I also propose the following: I worked for Merrill Lynch from 1982 to 1994. I experienced numerous "situations" there that deserve far more scrutiny than has ever been placed against them (or any large wirehouse), and the popular press is full of examples of the conflicts of interest that have existed there for decades. I left Merrill to join a far more consumer-advocate firm in 1994. I suggest that both SEC and FINRA start clamping down on their "consumer-unfriendly" abusive activities, and start making them toe the line as fiduciaries.