July 8, 2009
Schulmerich Associates, LLC appreciates the opportunity to express its views in response to the Securities and Exchange Commissions (the Commission) request for comments on the proposed amendments to Rule 206(4)-2.
As an investment adviser registered with the SEC, under Rule 206(4)-2, we are deemed to have custody solely because we have the authority to deduct advisory fees from our clients accounts, all of which are maintained by an independent, qualified custodian. We strongly believe that the portion of the proposed Rule, which would require advisers with this form of custody to undergo an annual surprise audit, is not warranted.
This appears to be a political reaction after the Madoff scandal rather than a measured regulatory response. I believe that the recent scandals that have occurred are due to a lack of enforcement of current rules by the SEC and FINRA. It seems unreasonable to create new regulations when the current once are not being effectively enforced.
The SEC already resolved one of the major problems with the custody rule, by eliminating a loophole from registration for certain accounting firms with the PCAOB that Madoff's accountant used to avoid detection of its auditing practices.
As required by current Rule 206(4)-2, the independent qualified custodian maintaining our clients accounts delivers account statements, on at least a quarterly basis, directly to clients, identifying the amount of funds and securities at the end of the period as well as all activity in our clients accounts. As a result, our clients receive comprehensive account information directly from the qualified custodian and are thus able to monitor the activity in their accounts. Furthermore, our clients agree, in writing, that our advisory fees will be deducted directly from their advisory accounts. These accounts are currently covered at TD Ameritrade through SIPC and Lloyds of London. In addition all reps with TD Ameritrade are required to carry errors and omissions coverage.
Accordingly, the safekeeping measures currently required by Rule 206(4)-2 provide our clients with the ability to sufficiently identify and detect erroneous or fraudulent transactions. It is also our understanding that abuses in the industry have not generally resulted solely because of arrangements whereby advisers have the authority to deduct fees from accounts maintained at qualified independent custodians. The absence of such actions supports our position that the safeguards mandated by current Rule 206(4)-2 are sufficient to deter advisers from engaging in fraudulent conduct.
Furthermore, the cost associated with an annual surprise audit would cause a financial strain on our company, the cost of which would most likely be passed on to our clients in the form of higher advisory fees, which is not in the best interests of our clients.
Given that existing safeguards in place are adequate and considering the adverse effects of a mandatory surprise audit on advisers as well as clients, we respectfully request that the Commission leave current Rule 206(4)-2 intact and unchanged with respect to advisers who have custody solely because they have the authority to deduct advisory fees from client accounts. We thank the Commission for the opportunity to comment on this matter.
If the commission believes that more disclosure of fees is needed to make the logical rule change would be to require custodians to provide a fee disclosure on the front of the monthly statement that is provided already.
In addition, as we imagine would be the case with other advisers, in the event we were unable to absorb and/or pass on the costs associated with an annual surprise audit, we would be forced to eliminate the direct debit of fees and instead require clients to pay our advisory fees directly. This would require a complete revamping of operations and would increase overhead costs. More importantly, in many cases, such a change in billing practices would confuse clients and require them to reorganize their banking arrangements, thereby adversely affecting our clients.
A change in billing practices would require the client to utilize non-retirement funds or take a distribution from their retirement funds to pay our advisory fee. This would adversely impact those clients whose substantial net worth resides in retirement accounts. The use of non-retirement funds could create a financial hardship requiring the client to take a distribution from their retirement funds creating taxable income and possibly a 10% penalty if they are not yet retirement age.
Schulmerich Associates, LLC