July 7, 2009
Regarding the proposed changes to custody rules, I believe it makes sense to have advisers whose only form of custody is the direct deduction of management fees from client accounts be excluded from the proposed custody rule provisions - namely the surprise financial audit. This form of custody is very low risk to the client from any form of abuse. When asked in a recent CCO Outreach, none of the Staff present could recall any case or action involving the abuse of the fee payment arrangement.
Additional regulation for fee payment custody would ultimately harm investors/clients. Clients would be inconvenienced by having to contact their custodian quarterly to initiate the sending of fees to their adviser. Ultimately, Advisors would pass along the added cost of regulation (both the direct cost of compliance and the added collection and bad debt expenses) for fee deduction in the form of higher management fees or in the form of fee payment provision amendments to existing management agreements.
The inconvenience and added cost to clients would not be offset by any added security to their funds. There would be little for a surprise auditor to audit for fee deduction custody advisors that is not already covered in the firm's compliance program and the custodian's back office operations. As part of any compliance program I have been affiliated with, there is a no less than annual test by reconciling fees paid with investment management contracted fee rates. Audits by SEC staff also look for the firm to provide documentation of this reconciliation. All transactions in and out of client accounts are monitored by the compliance programs and regulatory audit as well. Another check and balance lies with the client custodian. Custodians need additional documentation for any kind of deduction or transfer of funds in an account that are more or different than the customary fee deduction.
However,if the Commission does wish greater transparancy with fee deduction custodied advisors (or all advisors for that matter), having advisors commission a year end financial audit by an independent public accountant that is required to be submitted to the Commission (much as broker dealers submit audits to FINRA) would seem to be much more worthwhile in obtaining added transparency without interfering with what is currently an efficient, low risk method of management fee payment.
Lastly, and this is a bigger issue, the frequency of regulatory audits of advisers must be increased. In my consulting practice, many of the adviser clients have not seen the SEC in thier offices since inception for some of the newer advisors (5-7 years old) and the older advisers have not seen SEC staff in 10 or more years in some cases. In a era of contricted budgets, it is more difficult to encourage compliance with current regulation now when (in the adviser's view) they may not even get audited for another decade. With the current frequency of audits, there is incentive to let things go for a while and worry about catching up when it is years further into its audit cycle.
As an example, one firm was just audited and came through in reasonably good shape. The owners are older and planning to retire in 5-7 years. They think they have just under gone their last SEC audit. While I have little fear that their clients will always be well served, one does have to wonder what incentive does a firm like that really have to maintain and incur the expense of an up-to-date compliance system?