June 27, 2009
To the Commission:
I'm commenting here on Release No. IA-2876 File No. S7-09-09, Custody of Funds or Securities of Clients by Investment Advisers. I speak here as a financial consumer and financial writer--a constituency that the Commission doesn't hear from very often, but which, I think, has an enormous stake in its proceedings. If the Commission's mission is to protect us, then I hope the Commission will hear our opinions and lend them the same weight as the firms which will be commenting in this information-gathering forum.
In general, I think the proposal is a good one the SEC can eliminate, in one clear, concise rule, virtually all of the temptation and much of the fraud that exists when people who provide investment advice are also touching the client/customer's money. If all advisers or money managers were required, in all circumstances, to use an independent custodian, under the general definition of the Proposed Rule, then the regulatory process becomes much simpler: inspect the independent custodians and have regulations in place to ensure that they are properly handling client funds. These firms, typically, have much more to lose by engaging in Ponzi behavior or misapplying funds than others who provide investment advice your inspection should focus primarily on individual employees of these firms and the systems and procedures that are used to safeguard against various kinds of employee malfeasance.
So, first, I want to commend the Commission on its proposal, and I hope that, in general and with some qualifications that will be outlined below, you will speedily adopt this measure and require all investment advisers and money managers to custody client assets with an independent custodian not under their control. Please don't try to carve out a lot of exemptions.
I have a very small number of concerns with the Proposal as written, but I think these are entirely consistent with the spirit of my recommendations in the previous paragraph. First, on page 11, the Proposal states:
Should we except from thesurprise examination requirement advisers that have custody of client funds or securitiessolely as a result of their authority to withdraw advisory fees from client accounts?Isthis form of custody, which is common to advisers with discretionary authority, lesslikely to be subject to abuse? Should we instead specify requirements or restrictionsregarding withdrawing fees from client accounts? If so, what should they be?
Advisers who deduct advisory fees, through their custodians, do NOT put their hands directly on client money the activity takes place entirely through the custodian, under a contractual arrangement that is signed by the client. These arrangements have not been the subject of any of the scandals which were cited in the footnotes of the Proposal. Since custodians hold all client monies (which is what I would recommend be the case for all adviser assets), these advisory firms should fall under the general safe harbor proposed under the Rule--provided, of course, that the independent custodian sent independent account statements to clients on a regular basis, and provided, of course, that the fees to be debited are signed off on by the client. Surely this is sufficient safeguard, and far beyond the safeguards that existed in any of the heinous schemes listed in the footnotes of the Proposal.
As a financial consumer, I live under this arrangement currently, and feel quite comfortable that my assets are at all times where I expect them to be. I may not always like the ups and downs of the market, but I can see from the contract how much I'm billed, and I can see from the statements that no unapproved monies have been siphoned off into somebody's pocket. This, to me, is adequate protection, and I think it would be to any reasonable consumer.
In general, I am troubled by what appears to be a pattern emerging at the Commission: a trend toward imposing additional compliance expenses and paperwork burdens on independent financial advisers. In fact, the whole idea of proposing these independent audits on independent financial advisers looks, to those of us who write about investment subjects, like a disingenuous attempt to cripple the part of the advisory profession that has consistently and publicly advocated higher standards of service and protection than other members of the financial services community (brokers and brokerage firms) seem to want to provide. I would point out that on the ADV Forms, having the custodian debit advisory fees out of client accounts is not a definition of "custody," and this Proposal tells us straightaway that it would not change that.
So, to be clear, I believe the traditional advisory relationship, where monies are custodied at an independent custodian, falls well within the safe harbor provisions otherwise proposed in the Proposal. There is no need for an independent audit under these arrangements--and this applies not just to independent advisers, but to any advisory entity that agrees to custody client assets with an independent custodian.
However, if the Commission does want to strengthen consumer safeguards in this area, there are two ways that it can do this effectively and without unduly hampering independent advisers as they work with clients. First, the Commission could require investment advisers to send a bill to clients before the money is taken out of client accounts. The money could still come out automatically, but clients would be reminded of the fees they are paying. Many advisers follow this protocol currently.
Second, the Commission could impose a limitation on the total amount of a client's portfolio that can be billed during a single calendar year.
This might create some difficulties for the independent custodians, because some advisers offer advice on a client's 401(k) assets or other outside accounts, treating those other assets as part of the client's comprehensive portfolio for asset allocation purposes and monitoring, and bill for that service out of an account under direct supervision. Suppose, for example, a client had a 401(k) account worth $500,000, which the adviser could not bill out of, and $1.5 million in various accounts with, say, TD Ameritrade, which the adviser COULD bill out of. If the adviser billed, say, 1% on the total assets, and took this payment, under a contract signed by the client, out of the TD Ameritrade accounts, then the full $20,000 annual fee would come out of the TD Ameritrade accounts, and the percentage fee, based only on those accounts custodied at TD Ameritrade, would come to a little over 1.4%. This is what the fee would look like under any rule the Commission is likely to pass, even though it is, in fact, a 1% fee in what we investors refer to as "the real world."
What kind of limit would be reasonable? I would propose a 2% ceiling. However, this might engender a bit of concern among the brokerage firms who are commenting on this Proposal, since they routinely charge 3% on investment accounts. They may point out that some of that 3% represents the underlying asset management fee of separate account managers, but this might open up an interesting line of inquiry for the Commission. How much of that underlying asset management fee is shared with the brokerage firm, in what is apparently direct contravention to the rules governing shelf space arrangements laid down on mutual fund recommendations four years ago? (Many of us in the press believe that the Commission is asleep to this important issue, which represents a serious conflict of interest.)
Finally, I would strongly recommend that the Commission adopt the general premise of this Proposal without any changes other than those I have proposed here. I think all firms and all individuals who give investment advice to the public should have the assets custodied with a qualified custodian. No doubt, brokerage firms will take umbrage with this, but I don't think their argument holds water. If all of the brokerage firms were to custody client assets with each other, then one might plausibly assume that their custody business would be spread around as it is currently--but, of course, with one exception. If these firms were forced to buy their custody arrangements on the open market, then they might have more incentive to shop around for the best combination of service and fees--and it is not implausible to hope that this would benefit financial consumers in the long run.
And, of course, I believe that brokers and brokerage firms should be subject to the same rules as independent investment advisers--that, if the Commission decides to make these changes, they should bill for their services directly to consumers on a regular basis, custody assets with independent custodians, and live under a limitation of 2% a year for all client accounts.
I hope these comments are helpful as the Commission addresses these important issues and attempts to prevent significant abuses in the future.