June 30, 2009
To the SEC regarding Custody of Funds or Securities of Clients by Investment Advisers
First, this proposed requirement appears to be an outgrowth of the publicity surrounding the massive fraud of the Madoff Ponzi scheme. As such, the requirement for all investment advisers to be subject to an annual surprise audit does not address the underlying causes of that scam: the failure to require separate custody arrangements from trading and statement reporting the failure of the SEC to properly investigate legitimate leads about the potential scam the failure of the system to regulate hedge funds, or other entities designed to evade regulatory scrutiny and the enormous gullibility of investors.
For those of us with a smaller asset base (less than $100,000,000) the cost of an annual surprise audit by a major accounting firm is prohibitive and does little to prevent fraud. Even for larger advisers, I doubt that a surprise audit will uncover the kinds of abuse that you mention in your release. This type of audit will not prevent the unscrupulous adviser from perpetrating and hiding fraud. Dare I mention that Enron was audited and that we saw only what the auditors saw—not what was off balance sheet?
Furthermore, adding fraud detection to the list of duties for the Chief Compliance Officer (CCO) is not going to accomplish the task either. Do you really think that a CCO will be able to freely investigate such problems at his/her firm? Even a hint that the CCO suspects fraud and is investigating this possibility is going to close down avenues to finding it, as well as alert the perpetrators.
What I would like to see the SEC do is a random audit of a handful of client accounts when they make their surprise visits. They should verify directly with clients that the clients are receiving statements from the appropriate custodian, not merely reports from the adviser. Second, they should verify with clients that withdrawals are for adviser fees, or other authorized services, and in the appropriate amount. Third, they should verify that permission was granted for non-discretionary trades. Fourth, they should look at the suitability of investments in the portfolio given the clients age, risk tolerance, and stated goals. This is the most obvious place to begin the fraud detection process.
Clearly, your alternate proposal of requiring advisers to use independent custodians would address many of the concerns voiced in this release.
Finally, if you do put this onerous, unnecessary, costly, and burdensome rule in place, I would urge you in the strongest terms possible to make an exemption for advisers who maintain custody by virtue of merely withdrawing fees.