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SEC Proposes Rule Amendments to Strengthen Safeguards of Investor Funds Controlled by Investment Advisers


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Washington, D.C., May 14, 2009 — The Securities and Exchange Commission today proposed rule amendments to substantially increase protections for investors who entrust their money to investment advisers.

The SEC is seeking public comment on the proposed measures, which are intended to ensure that investment advisers who have “custody” of clients’ funds and securities are handling those assets properly. In some recent SEC enforcement actions, firms and principals have been charged with misusing clients’ money and covering up their illicit activities by distributing false account statements showing non-existent funds. The additional safeguards proposed by the SEC include a yearly “surprise exam” of investment advisers performed by an independent public accountant to verify client assets. In addition, when an adviser or an affiliate directly holds client assets, a custody control review would have to be conducted by a PCAOB-registered and inspected accountant.

“These new safeguards are designed to decrease the likelihood that an investment adviser could misappropriate a client’s assets and go undetected,” said SEC Chairman Mary Schapiro. “That’s because an independent public accountant will be looking over their shoulder on at least an annual basis.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “The amendments proposed by the Commission today would significantly strengthen controls over client assets held by registered investment advisers — especially when those assets are held directly by the adviser itself or a related person of the adviser.”

Unlike banks or broker-dealers, investment advisers generally do not have physical custody of their clients’ funds or securities. Instead, client assets are typically maintained with a broker-dealer or bank (a “qualified custodian”), but the adviser still may be deemed to have custody because the adviser has authority to withdraw their clients’ funds held by the qualified custodian. Or the qualified custodian may be affiliated with the adviser, which may give the adviser indirect access to client funds.

The SEC’s proposed rule amendments, if adopted, would promote independent custody and enable independent public accountants to act as third-party monitors.

One proposed amendment would require all registered advisers with custody of client assets to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.

Another proposed amendment would apply to investment advisers whose client assets are not held or controlled by a firm independent of the adviser. In such cases, the investment adviser will be required to obtain a written report — prepared by a PCAOB-registered and inspected accountant — that, among other things, describes the controls in place, tests the operating effectiveness of those controls, and provides the results of those tests. These reports are commonly known as SAS-70 reports. This review would have to meet PCAOB standards — providing an important level of quality control over the accountants performing the review.

The proposed measures also would include reporting requirements designed to alert the SEC staff and investors to potential problems at an adviser, and provide the Commission with important information for risk assessment purposes. An adviser would be required to disclose in public filings with the Commission, among other things, the identity of the independent public accountant that performs its “surprise exam,” and amend its filings to report if it changes accountants. The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement. If the accountants find any material discrepancies during the surprise examination, they would have to report them to the Commission.

The proposed amendments also would require that all custodians holding advisory client assets directly deliver custodial statements to advisory clients rather than through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser. These additional safeguards would make it more difficult for an adviser to prepare false account statements, and more likely that clients would find discrepancies.

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Public comments on today’s proposed rule amendments must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule amendments will be posted to the SEC Web site as soon as possible.



Modified: 05/14/2009