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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Statement at SEC Open Meeting on Strengthening Safeguards to Protect Clients’ Assets Controlled by Investment Advisers


Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission

Washington, D.C.
December 16, 2009

Next, we will consider a recommendation to adopt rules to enhance the custody controls that apply to investment advisers.

Our goal when this process began was to strengthen the protections provided to investors who turn over their assets to investment advisers. I am pleased that today’s rules, if adopted, will achieve that goal.

The rules we are considering grow out of the Madoff Ponzi scheme, and other frauds in which investor assets were misappropriated by investment advisers. Such frauds have caused investors to question whether their assets are safe when they entrust them to an investment adviser.

I believe today’s rules will help to put their minds at ease.

Over the past several months, we have fine-tuned the rules to apply the safeguards where those safeguards are needed most — where the risk of fraud is heightened by the degree of control the adviser has over a client’s assets.

Most advisers today actually do not maintain physical custody of their clients’ assets. Instead, those assets are held by a qualified third-party custodian, such as a regulated bank or a broker-dealer. In turn, that qualified custodian sends a quarterly account statement directly to the client who can see whether the account statement reflects the assets the client believes exist. Under such arrangements, particularly where an independent custodian holds client assets, the risk of client assets being misused is limited.

But, in several situations there is heightened opportunity for an adviser to misappropriate a client’s assets and convert those assets to their own personal use. Today’s rules will institute important new controls to guard against possible foul play in those situations.

Self- and Affiliated Custody: The first set of situations where there is a heightened potential for fraud involves the adviser who serves as the custodian and actually holds onto the client’s assets — such as the Madoff firm did. And, the related situation where the custodian is affiliated with the adviser.

In these cases, the heightened risk stems from the fact that the assets are not being held by a fully independent party who can serve as a check on fraud and misappropriation.

Under the new rules, these advisers, at least once each year, would be subject to a “surprise exam” by an independent auditor in order to verify client assets. If evidence reveals missing assets or material discrepancies during the surprise exam, the auditor would be required to notify the SEC within one day. This will give the agency a direct line into potential frauds at an early stage.

The surprise exam would not, however, be required if the adviser is deemed to be operationally independent of the affiliated custodian — that is, where the adviser and the affiliate operate as distinct entities with no overlap of personnel, office space or common supervision.

In addition to the surprise exam, all of these entities that actually hold client assets — be they advisers, affiliates or operationally independent affiliates — would have to undergo an annual review of the controls they have in place regarding custody. That review will have to be conducted by an independent accountant that is registered with and subject to regular inspection by the PCAOB.

The surprise exam and the custody controls review will work to provide assurance that client assets, as reported to the client, exist and are properly held by a qualified custodian.

It is my expectation that the new rules will encourage the use of fully independent custodians because these measures would not be required under such arrangements. I encourage all advisers and their clients to consider this approach.

Advisers with Enhanced Authority Over Client Assets: The next situation where we are significantly enhancing safeguards involves advisers who have authority over their clients’ assets. This occurs, for example, where an adviser serves as trustee to a trust, has a power of attorney, or has the ability to write checks on a client’s account, even though the adviser uses an independent custodian.

Where the adviser has this significant level of control over clients’ assets, there is a potential risk that the adviser could easily misappropriate the funds. And the only check on the adviser’s activity is for the clients to review and understand the statements they receive from the custodian and identify anomalies or debits that shouldn’t be there.

Unfortunately, these clients are often the very same clients who, because of their own life circumstances, are not able to closely monitor their accounts. They may be elderly, incapacitated or frankly too busy.

In the last year alone, the Commission has considered several cases in which advisers allegedly stole money from client accounts and the clients, many of whom were elderly, did not notice the money was missing. In one case, we alleged the adviser drained $23 million from the clients’ accounts. In another, $6 million. No matter the size, it’s a breach of trust for the investor who relies on an investment adviser.

For these advisers who have an enhanced ability to control their client’s assets, today’s rules will require, for them as well, a surprise exam. These rules are designed to protect the very investors who need us the most.

When an adviser takes on the privilege and responsibility of having unfettered access to a client’s money, particularly a client who is elderly, infirm or has compromised mental capacity, there is, I believe, the need to have an auditor’s “second set of eyes” confirm that those assets exist.

However, we acknowledge concerns raised by commenters regarding the impact of this new requirement on small advisers and their retail clients, who may be more likely to enter into these types of arrangements. As a result, we are directing our staff to study the impact of these surprise exams on smaller advisers and their clients and report back to us following the first year of audits. We will use this study to assess whether modifications of the rule are necessary to improve its effectiveness or reduce unnecessary burdens.

Fee Deduction: Separate from the situation I just described, is the situation where the adviser uses an independent custodian, and merely has the ability to deduct fees from the client’s accounts. This relatively limited form of custody has not, to date, presented the same opportunity for fraud and misappropriation as the situations for which we are enhancing additional controls. That is why the rules we are considering today would not mandate a surprise exam in these circumstances.

Instead, the adopting release we are considering today will identify controls and procedures related to fee deduction that advisers should consider in order to assure that investor assets are appropriately protected. In addition, I have asked our examination staff to focus on fee deduction issues as they conduct investment adviser examinations.

Other Reforms: Today’s rules will also impose an important new control on advisers to hedge funds and other private funds by requiring that any auditor that audits a private fund be registered with and subject to regular inspection by the PCAOB. I agree with commenters’ assessment that the requirement to obtain a surprise exam and also have an annual audit of the hedge fund would be largely duplicative.

However, I believe PCAOB registration and inspection will serve as an important screening mechanism for these auditors. In addition, I support the staff’s efforts to continue to consider ways to enhance the custodial controls for private funds, within our jurisdictional framework.

The new rules also require that the adviser reasonably believe that the client’s custodian delivers the account statements directly to the client, to provide greater assurance of the integrity of these account statements, and so that clients can compare the account statement they receive from their adviser to determine that the account transactions are proper.

We also are considering amendments to require additional public disclosure about the use of affiliated custodians and disclosure of the auditors performing surprise examinations, so that the quality of custodial arrangements and controls can be better monitored. The new rules also require auditors to explain the basis for the ending of their service to an adviser. This so-called “noisy withdrawal” can serve as a red flag for our staff and the adviser’s clients. In addition we will consider issuance of an interpretive release updating 1960s-era guidance on conducting surprise exams as well as guidance on the internal control report.

I am committed to adopting effective and meaningful rules to protect client assets. And I am committed to doing so based on what I believe to be in the best interest of investors. Today’s package of rule adoptions represents a significant strengthening of our custody controls and an important step in reassuring investors that the regulatory system will be there to protect them.

For now, I'll turn the meeting over to Buddy Donohue, Director of the Division of Investment Management, to hear more about the Division's recommendation. Before I do that, however, I would like to thank those who have worked tirelessly with Buddy to prepare the recommendation before us today: Bob Plaze, Sarah Bessin, Dan Kahl, Melissa Roverts, Vivien Liu, Rick Sennett, Bryan Morris and Jaime Eichen in the Division of Investment Management; Paul Beswick in the Office of the Chief Accountant; Jill Felker, Lori Price, Jeff Singdahlsen and Meridith Mitchell in the Office of the General Counsel; Gene Gohlke in the Office of Compliance Inspections and Examinations; and Chuck Dale, Woodrow Johnson and Adam Glass from the Division of Risk, Strategy and Financial Innovation. Thank you.



Modified: 12/16/2009