July 15, 2009
Clearly the commission should address obvious loopholes that provide opportunity for malfeasance without placing an onerous and costly burden on RIA firms unnecessarily. Self-funding of surprise audits should not be a blanket requirement for all firms. It should depend on how the RIA business model is set-up. Many RIA firms provide a sufficient layer of protection for clients and the commission should provide these firms an exemption. Here are my suggested considerations:
1. When common ownership exists between the RIA and the custodian, there is a lack of arms-length operations and the check-and-balance process is absent. This is where some manner of independent audit/review may identify impropriety on behalf of clients.
2. I would propose the audit criterion be specific and refrain from going beyond its intended purpose. An outside audit is only needed where it addresses the underlying problem: lack of independence between RIA, B-D and custodian firms.
3. I further propose that a more measured rule change be given due consideration where inter-related RIAs/custodian firms are concerned. Modify the rule to require client-initiated audits if the RIAs are financial or personally related to custodians for client accounts. These are not random annual audits, but specific audits conducted by an outside certified auditor when requested by a client. The RIA should bear the audit costs if errors or improper behavior are discovered. If no problems are reported, then the client pays for the audit to prevent frivolous accusations. Clearly this presents an equitable means to satisfy client concerns of impropriety and allows the client to select the audit firm. Permitting the client to select the auditor prevents collusion by auditors and RIA/Custodians to defraud clients.
4. The rule should exempt advisors that have custody solely as a result of their authority to withdraw advisory fees from client accounts. To qualify for this exemption the advisor must be completely independent of the custodian. That means no common ownership or interest by the RIA and custodian firm. The quarterly client investment reports are issued by an independent firm that is not controlled or influenced by the RIA. Thus the client can confirm the appropriateness of their holdings and fees. That independence provides reasonable and prudent protection to clients. This incents RIAs to be totally separate from custodians, thus making the investment advice they provide more independent to the client.
5. The commission should maintain the legal principle of a “reasonable and prudent” client. The rule should not assume to protect a client of their own negligence. When fees are deducted from a client account, an audit is an excessive requirement for independent RIAs since 1) the client has a copy of the RIA agreement that states the fee terms, 2) the RIA issues a quarterly statement for fees being withdrawn and 3) the independent custodian sends a quarterly client statement that reflects the advisor fees paid from the account. This is sufficient for verifying proper fee payment by a reasonable client. This three-way check is part of SEC and state commission routine reviews conducted on RIA firms.
It is unfortunate that the investment services industry developed over decades as an integrated model. This system favors the integrated firms, not the client. It would be reasonable to suspect any prescription written by a doctor, when the drug company, the pharmacy and the physician were all structurally related. Under that system, there is ample latitude that the prescription is benefiting a related entity. That is typical for integrated Investment Advisors-Broker/Dealers-Custodians today. Regulatory rule-making should protect against such a model and discourage it. Let’s not encumber independent RIAs which only give professional advice, similar to independent physicians.
Covenant Advisors LLC