Speech by SEC Commissioner:
The Need to Strengthen Custodial Practices to Protect Investors and Their Assets
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
December 16, 2009
A year ago, in the midst of the worst economic downturn since the Great Depression, the markets were further roiled by the revelation of the Madoff Ponzi scheme. The Madoff scheme was a massive, long-lived fraud that devastated the lives of many. I know this package of proposals is going to be heralded as the Madoff fix — but we need to recognize that this is just an incremental step, and there is much more to be done. It is disappointing that the package of proposals in front of us does not go further to implement the lessons of Madoff by including proposals regarding the custody of assets at broker-dealers.
Madoff Conducted His Fraud as a Broker-Dealer for Decades
It's important to recognize that the Madoff Ponzi scheme lasted for decades — potentially starting in the 1980s — and for much of that time Madoff was registered only as a broker-dealer. The victims lost money from discretionary, commission-only brokerage accounts. It was only in 2006 that Madoff registered as an investment adviser. Thus, even if today's rule had been in effect, it would not have applied to the Madoff broker-dealer that existed for the duration of the fraud. Accordingly, this rule would not have prevented much of the harm that Madoff did.
The Commission is concentrating on a very small slice of the custody picture. Today's rule focuses solely on adviser custody rules. Not only was the vast majority of the Madoff fraud conducted by a brokerage firm, but the vast majority of investor assets in America are not held by investment advisers.
We know that Madoff was able to circumvent broker-dealer regulation for decades. Broker-dealer regulation is a combination of direct FINRA inspection and regulation and SEC oversight. It is impossible for me to have confidence that other fraudsters cannot continue to operate as broker-dealers and exploit some of the same weaknesses to end-run FINRA or to end-run the SEC.
For the sake of investors, I look forward to the staff proposals to strengthen the broker-dealer framework, which should be informed by a comprehensive look into how Madoff circumvented the broker-dealer and self-regulatory rules. This should be at the top of the Commission's agenda.
Most Advisers Do Not Physically Hold Client Assets
Let's face it — very few advisers hold physical custody of client assets. Currently, investment advisers are required to maintain their clients' assets with qualified custodians, such as banks and broker-dealers.
Typically, the qualified custodian is an independent third party — in fact, investors often independently choose their custodian. By contrast, there are some investment advisers who either use a custodian that is an affiliate, often a broker-dealer, or who self-custody by dually registering as a broker-dealer. Thus, for investment advisers, the SEC's custody rules have always taken a layered approach. In other words, the investment advisory rules are layered on top of the broker-dealer, or banking, regulations governing customer asset protection.
Accordingly, tightening the rules applicable to investment advisers without assessing and strengthening the underlying broker-dealer rules is not enough.
Advisers Using Independent Custodians that Have Broader Authority
I now want to turn to specific provisions of the rule. I am concerned about the costs of a surprise exam for advisers who have authority to withdraw client funds or securities from the independent custodian — for example, when the adviser serves as a trustee to a client's trust or holds a client's power-of-attorney. Having an independent custodian is an important safeguard which, when added to the other new mandates, may cause the costs of a surprise exam to be overly burdensome and not justified by the benefits.
For example, these new mandates include requiring custodians to deliver statements directly to clients so that clients can verify their holdings. In addition, any statement sent by the adviser directly to the client will be required to contain a notice reminding the client to compare the account statement received from the adviser with the statement received from the custodian. These are strong protective measures in and of themselves. All the client needs to do is open the envelope from the custodian.
Furthermore, as reflected in the record, most of the advisers with authority to withdraw client assets have longstanding relationships with clients that have asked the adviser to serve as their trustee. Moreover, the advisers typically provide these services for free (or for very low fees). The record also indicates that clients often choose their custodians independently of the adviser's influence.
The staff estimates that approximately 1,315 advisers may have such authority, but only as to a small percentage of their clients — estimated to be 5% or fewer. The SEC staff further estimates that over 90% of these advisers are among the smallest advisers registered with the Commission.
It would be a terrible result for investors if, because of the disproportionate costs of a surprise audit related to only a small number of accounts, advisers were unable to continue to serve as trustees for their long-term clients at little or no cost. Unfortunately, I fear our rule will have this effect.
PCAOB Registered Auditors Are Required, But Are Not Inspected for Adviser Expertise
Let me now discuss the requirement to use PCAOB registered auditors. I do support the use of PCAOB registered auditors because, too often in these fraud schemes, the auditors are embroiled in the scheme. By requiring that PCAOB registered and inspected auditors undertake both the surprise audit and the internal control report, the Commission is hoping to fortify the auditors who take on these engagements as truly independent third parties. It is important to note, however, that the PCAOB will not be inspecting the audit work performed as a result of this new custody rule. I am concerned that the PCAOB registration requirement will lull investors into a false sense of comfort. Although I do think on balance that requiring the surprise audit to be done by PCAOB registered auditors is the right thing to do, and that it does provide increased investor protection, this is not a long-term solution. We have asked the staff to monitor the situation and inform us if issues arise. It is my hope that the PCAOB soon will be empowered and resourced to make the necessary inspections.
Who Does it Cover?
At the end of the day, the staff estimates that, under these new rules, 1,859 out of the universe of 11,300 investment advisers will be required to obtain a surprise audit. On balance, I think these new requirements are a small step in the right direction, and I am willing to support them.
In closing, I join my colleagues in thanking the staff of the Division of Investment Management, the Division of Risk, Strategy and Financial Innovation, the Office of Compliance Inspections and Examinations and the Office of the General Counsel for all of their hard work in preparing today's adopting release. Just as importantly, I want to thank the staff of Trading and Markets for their pending work in reviewing the custody arrangements of broker-dealers. I encourage them, and this Commission, to do the work quickly and thoroughly so as to better protect investors.