July 23, 2009
To Whom It May Concern:
A surprise audit will, if properly executed, safeguard investor interests. However, the rule as currently designed, threatens to place undue burden on RIAs, particularly smaller advisors that serve as a vital, alternative expertise to the many individuals that necessitate a closer working relationship with their trusted advisor. Simply put, the expense burden and the lost hours will unduly favor larger firms. The question is, “What is achieved by this?”
Many firms, such as my own, do not have any effective custody or control of client assets. We bill in arrears. We strictly prohibit the receipt or possession of stocks/bonds in certificate form – everything must be held in street name, and all transfers into a client’s account are handled by the custodian…stock certificates/stock power forms go directly from the client to the custodian. Checks, wire transfers, and deposits, are handled independent of our office. Our custodian forbids third-party checks from client accounts without explicitly executed instructions (which includes client signature). As a result, when looking at our business and many other businesses substantially similar, the prospect of a surprise audit achieves nothing other than raising the cost of doing business, which is ultimately borne by clients over time whether through direct increase in fees or less competition.
As a result, my recommendations would be the following:
In the case of an RIA having custody or access to the assets in client accounts, a surprise audit is a reasonable safeguard. In the case of an RIA billing in advance, a surprise audit is a reasonable safeguard. However, the cost burden can be prospectively mitigated by some simple procedural changes. For example, each custodian should be responsible for adhering to a rule that enables an RIA that is accessing client assets to only transfer those assets into a specially RIA administered audit account. The act of each transfer thus becomes the first line of review….or, namely, the cumulative amount of transfers allows a prioritization for audits. Importantly, such auditable acts must ALWAYS first transfer from client accounts into this specially designated account. No exceptions. The same setup can apply for RIAs billing in advance. And, importantly, the fee schedules can and should be shared with the custodian, so not only do such fees form a basis for audit, but the awareness of appropriate billing by the custodian in itself becomes a safeguard. Same for any other circumstance under which an RIA might access client assets through a custodial capability or power of attorney.
If an RIA bills in arrears, however, there should be no such requirement. How will the custodian know if an RIA bills in arrears or in advance? Simple-- client should be required to initial/sign a new section of the account applications explicitly authorizing the RIA to deduct fees, and this authorization will require language so that the custodian obtains full knowledge and disclosure of whether this authorization is in arrears or in advance, and the fee rate.
In aggregate, these modifications would rightly limit the number of audits, prevent useless audits where an RIA does NOT in fact have any sort of custody of client assets, and set a valuable framework from which to prioritize which firms should be most closely monitored. Importantly, requiring custodians, under auditable actions, to ONLY release client assets into an account that is opened/created for this sole explicit purpose would be cheap, low cost, easily implemented, AND allow for more immediate safeguarding/supervision/regulatory action in response to unauthorized activity. Also, the reporting structure back to the SEC for determining the audit prioritization would be simple.
Thank you for taking the time to review our response. Feel free to contact us with any questions or follow up.
Jon Ferguson