Speech by SEC Commissioner:
Statement at SEC Open Meeting
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
May 14, 2009
I also want to thank the Division of Investment Management, the Office of General Counsel, and the Offices of Chief Accountant and Economic Analysis for their contributions to this release.1 And thanks to the Chairman for her leadership during her first three and a half months back at the SEC. I share her commitment to ensuring that the Commission is effectively meeting its vital mission of ensuring the protection of investors. And I know that it is in this spirit that we are considering today's rulemaking.
Rule 206(4)-2 was first adopted in 1962, shortly after Congress amended the Advisers Act to provide the Commission with rulemaking and inspection authority under the Act's antifraud provisions. The rule was designed to address concerns about the custodial practices of advisers and the safety of client assets — a key issue then as it is today. Over the next forty years, the Commission made no substantive changes to the rule. Instead, our staff addressed evolving business practices and clarified the rule's operation through no-action letters, interpretive letters and releases.
During 2002 and 2003, in considerably less volatile market conditions, the Commission decided to make several fundamental changes to the rule. I understand that this was a careful and nuanced process, and the final rule achieved a careful balance among fostering investor protection, respecting the complexity of custodial practices, codifying certain staff positions, and imposing a highly reasoned set of requirements on market participants. Without question, however, we are in a considerably different market environment today.
Significant declines have led to the implosion of a number of Ponzi schemes and revelations of other kinds of misconduct. Despite diligent work by our Enforcement staff to quickly root out these frauds, the Commission is also evaluating whether additional protections would enhance our ability to ensure the protection of investors from such schemes. Our custody rule, as it is designed to provide important investor protections, is a logical area for us to focus and consider whether it is operating effectively or could be strengthened and improved.
As we do so, we must be clear as to how proposed changes would or would not likely protect investors against similar frauds. And we must balance the additional costs that accompany the proposal against the value of the additional protections we hope to achieve. To the degree that flaws in custodial practices or the custody rule itself are not at the heart of the matter, we must be confident that these proposals do more than give false assurances against similar frauds given the costs these amendments would impose on investors and advisers.
The proposals before us today make certain significant departures from the judgments made in 2003 about the efficacy and operation of the custody rule. For the sake of discussion, I will make the assumption that some change is appropriate and move to the next question — whether the proposal before us makes the right recommendations to improve custodial practices. This question has a global and a particular dimension.
As a global matter, I agree with those who think that what we most need is a wholesale reevaluation of our approach to investment advisory and broker-dealer oversight and conduct. Custodial practices are certainly an essential part of any such discussion. Thus, it would be my preference to have the chance to evaluate the broader regulatory scheme than to work piecemeal through incremental changes or to build out new requirements (potentially very costly requirements) that we — perhaps at the direction of Congress — may soon need to set aside in favor of entirely new regulations. I acknowledge that this will require legislative action, but it does give me pause to engage in rulemaking related to one component of the Advisers Act when there are much broader issues for us to consider.
More particularly, I think we already have a good rule from 2003 that — for the vast majority of advisers, who are law abiding, regulation-observing entities — outlines a sensible approach to custodial practices. I therefore believe that we can better improve the rule by way of surgery instead of wholesale reengineering.
That said, because (1) I believe we must always be considering whether we can be more effective in providing greater assurance and protection to investors and I know we will hear from those most affected by the proposal — namely, the investors who will pay for it and the advisers who will have to devote substantial effort to implementing it-and (2) I think that the draft is shaped in such a way that we can further calibrate these proposals to more finely target and achieve improvement to the rule, I am supporting the proposing release today.
But there are several key areas that I strongly believe warrant additional thought and analysis:
Scope: We are significantly expanding the universe of those captured by the rule. In particular, I am concerned about the way we are defining custody for the purposes of the surprise audit requirement, particularly the broad swath of players we now will be bringing into its orbit. We need to evaluate the added protection for investors that would come from applying the surprise audit requirement on firms that do not actually have custody of customer assets in any meaningful sense, but are deemed to by virtue of their ability to deduct fees.
Cost/Benefit: More broadly, I am concerned also about some of the other costs we may be imposing for what may be limited added protection for investors. We need good answers to support a proposal with a significant potential price tag. While actual costs may prove lower in the final analysis, I fear, as is often the case, the real impact could just as easily be significantly more than what we contemplate today. Our experience with Section 404 of Sarbanes-Oxley is an early lesson in the cost and benefits that come with the imposition of internal control audit requirements.
Market Impact/Investor Choice/Competition: There are a number of ways to tackle this question, but one of them is whether and how many legitimate small- and mid-sized firms are likely to be affected or driven into consolidation with competitors by the costs associated with the rule. Specifically, we need to ask tough questions about the utility of the internal control audit proposal and the associated registration and inspection standards for the accountants who will perform this function and how much incremental protection such requirements are likely to provide investors.
Thank you, again, to the staff for bringing us this proposal. I have a few questions.