Advisors Tell SEC to Rethink Proposed Custody Rule

Overwhelming Majority of Investment Advisors Disagree with Proposed Changes to Custody Rule

In an effort to deter fraudulent activity, the SEC has proposed to amend Rule 206(4)-2, also known as the ‘custody rule’, to require that all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets. According to this proposal, there would be no exception to the annual surprise inspection requirement for advisors who possess custody of client funds solely because they withdraw funds from client accounts for payment of a client’s fees. Of the 20 responses submitted to the SEC by investment advisors and related industry professionals, 2 respondents supported the proposal and 18 respondents were opposed. Several  of the respondents on both sides of the issue concede that, for those cases where a registered investment advisor does not use a qualified independent custodian, the proposed legislation offers a necessary higher level of scrutiny and oversight.

Respondent Rosamond R. Dewart, retired federal employee, states:

 ” I would support the proposed rule if […] it could accomplish the intent of the rule. Investment  advisers certainly need more scrutiny. I have lost confidence in the entire financial sector.”

However, the majority of respondents argue that the surprise examination requirement will grossly and negatively impact small-to-medium advisers who fall who only possess ‘custody’ of client accounts as described above. 

Carolyn Santo, a CFP from Hawaii, asserts in her response:

 “The proposed changes to the SEC rules involving making investment advisors pay for surprise  audits on themselves is a classic example of an unwieldy and clumsy attempt to protect the  investing public from a super micro-minority in the world of white collar crime.”

Those opposed to the proposed changes argue that, due to a number of recent enforcement actions against investment advisors alleging fraudulent conduct , many regulators and politicians assume that the ability to withdraw fees from a client account gives investment advisors complete control of the cash inside the account. Many assert that this assumption is simply not true, and additionally point out that the costs assumed for the surprise audit may be unrealistic and unfair to small-to-medium advisors, forcing some advisors to pass these costs along to client investors.

Peter J. Chepucavage, General Counsel of Plexus Consluting LLC, states:

 ” We think the added cost is disproportionate to the added compensation, a fact often present  in one size fits all regulation.”

Another respondent, John M. Smartt, Jr., CPA, adds:

 ” The additional proposed regulation, annual audit, is a significantly higher cost without  significant benefits. An estimated $8,100 audit charge would cost me more than 10% of my  current gross income (as a Tennessee RIA)”.

Some opposed to the new regulation have offered some constructive suggestions as to compliance alternatives that the SEC ought to consider:

  • Changing the definition of “custody” for accounts held at regulated third party custodians such as brokerage firms and/or trust companies
  • Increasing public knowledge by disseminating information about the entire industry
  • Increasing investigation of Red Flag situations (i.e. large withdrawals and lavish spending)
  • Establishing a substantial reward for information leading to the discovery of a financial scam
  • Requiring a higher level of disclosure of the independent custodian to the client when cumulative withdrawals are greater than an established percent of the account’s value for the prior quarter.

With regards to the suggestion for greater disclosure, Warren Mackensen, founder of Mackensen & Company, Inc., strongly encourages the SEC to implement the following additional four (4) client protection controls for advisers who debit fees from client accounts to avoid unnecessary an costly annual surprise examinations by a CPA firm:

  • Requiring custodians to limit fee deductions to, say, 2%, which would provide sufficient investor protection that the adviser is not absconding with client assets
  • Requiring at least quarterly statements directly from the qualified custodian (our clients receive monthly statements)
  • Requiring the custodians to send statements in any month in which a client fee was deducted (more immediate notice to the clients if statements are otherwise quarterly); and
  • Requiring the investment adviser to send an invoice showing the fee calculation directly to the client so that the client may compare the fee computation with his/her monthly statement showing the debited fee.

Others opposed to the proposed changes have noted the following additional points with regards to client protections already in place when an adviser uses a qualified custodian:

  • The third party custodian already acts as a gatekeeper to the advisors ability to pull funds from client accounts, making it virtually impossible for a an advisor using a major third party custodian, such as Charles Schwab, TD Ameritrade, Fidelity, etc.) to ‘drain the account’ through fees, as they will not process withdrawals that exceed a certain percentage per year. 
  • Any advisor who is able to deduct fees from client accounts needs written authorization to make payments to anyone other than the client, adding an extra layer of protection for the client.

Overall, it appears that the overwhelming response to the proposed legislation indicates that the majority of investment advisors would prefer that the SEC adopt less costly and less time-consuming compliance alternatives  to maximize investor protection.  With regards to the anticipated effectiveness of the proposed legislation, Carolyn Santo writes,

 ” The wrongful taking of client assets is a criminal act, and increasing the regulatory burden on  the entire industry is not going to lessen the fact that a small number of people are dishonest  and will steal from clients.”

To view all comments submitted to the SEC regarding the proposed amendments to Rule 206(4)-2, including discussions from the above-cited respondents, please visit:

2 thoughts on “Advisors Tell SEC to Rethink Proposed Custody Rule

  1. Pingback: Mallon P.C. Comments on Proposed Investment Adviser Custody Rule — Hedge Fund Law Blog

  2. Ann

    What new custody rules apply to self directed IRAs? Currently a third party custodial institution merely transfers the money based on instructions from the adviser and is not required to do anything more than send out statements with the initial investment amount and a referral to the adviser for current value.

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