July 28, 2009
I strongly object to the proposed revision of Rule 2006(4)-2 that would require investment advisors using an independent, third party custodian for their client’s assets, but collect their investment management fees from a client’s account, to contract for a surprise audit by an independent public accountant.
I am a sole proprietor and a member of the Financial Planning Association (FPA) and the National Association of Personal Financial Advisors (NAPFA). For a small firm, such as mine, this requirement is especially onerous because this surprise audit requirement will significantly increase my cost of doing business, an expense I cannot absorb. And, I suspect that I would lose some of my clients to bigger advisors who could spread the cost over a larger client base if I had to renegotiate my client contracts.
This proposed surprise audit appears to be more of a political reaction to public criticism of the SEC and congressional pressure rather than a well thought-out, effective regulatory response. As far as I am aware, there have been few systemic problems in this area so this new requirement appears unnecessary as well as costly and burdensome for small investment advisers.
While developing this response, it occurred to me that the problem may be the current definition of “custody” or the lack of separate procedures for investment advisors who use an independent, third party custodian and merely collect their fees from client accounts. Why does collecting a fee from the client’s account constitute “custody?” It seems logical to me that an advisor using an independent, third party custodian should not be viewed as having custody, but should be in a new category such as having “Limited Access.” At least, I recommend that the Custody Rule be revised to eliminate the fee deduction authority test as a basis for establishing advisor custody when an independent, third party custodian is used.
The SEC is doing the right thing by trying to identify ways to further protect consumers from criminals and scam artists, but this proposal will hurt a significant number of small advisors and will do little to aid investors. The problems you are trying to address seem to come from investment advisors who self-custody, or custody with an affiliated organization or use pooled investment funds. An advisor who uses an independent, third party custodian for individual accounts has little chance to steal assets or charge exorbitant fees because the client, the custodian, and the regulators are all watching.
To enhance consumer protection, I would support Congress appropriating additional resources to the SEC to hire and train additional examination staff to shorten the regular audit cycle of investment advisers. I also recommend the SEC require that all advisors provide written fee notifications to clients at or about the time fees are withdrawn from client accounts through independent, third party custodians, which I thought was still required. It also seems reasonable for the SEC to provide clear fee guidance as to the maximum permissible advisory fee rate that an advisor can deduct through an independent custodian.
Finally, consumers need to be empowered with the right tools and resources to help them vet advisors who will work for their best interests. I, therefore, believe the SEC should, at a much lower cost, assist consumers by encouraging them to thoroughly read and review all statements to identify questionable account activity, offer incentives for whistleblowers that bring to light dishonest advisor activity, and provide investors the ability to report fraudulent activity anonymously.
In closing, I commend and support your efforts and the quality of the analysis that went into the proposed revision of Rule 2006(4)-2. I also appreciate your seeking industry comments and input. I fully support trying to prevent fraud and theft by detecting investment advisory firm problems early because these people hurt my business. I also want to see consumers protected from unjustified or exorbitant fees because I am tarnished every time some consumer is hurt by this practice. My concern, as addressed above, is that this surprise audit proposal is unnecessary for advisors using independent third party advisors.
Sincerely,
John Ellison
Ellison Investment Advisors