Investment advisors, clients, and the Custody Rule: surprise examinations are your friend

The Securities and Exchange Commission’s Custody Rule also has the moniker of the “Anti-Madoff rule,” referring to Bernard Madoff, the infamous financier who made a mammoth fortune – and went to prison – for manipulating other people’s money. But Madoff wasn’t swimming alone at that beach. There are rule-bending and law-breaking people in all fields. Investment advising, just like every other craft and profession, has bad apples.

The SEC is looking increasingly hard at Custody Rule violations to help ensure fraud isn’t perpetrated against investors. The Custody Rule, in general, requires clients’ assets to be kept separate from an investment advisors control; that third-party custodians, not the investment advisor, send quarterly account statements to clients; and that a surprise inspection by an independent public accounting firm be made annually of the investment advisor to verify client assets.

The actual definition of investment advisors, while seemingly obvious on its face, becomes complicated depending on who is offering advice, how money is involved, and where funds are held. The SEC has an overall definition:

“An advisor has custody of client assets, and therefore must comply with the rule, when it holds, directly or indirectly, client funds or securities or [has] any authority to obtain possession of them."

The surprise inspection component of the Custody Rule makes up one of the first lines of defense in terms of ensuring that investment advisors are ensuring the safety of client assets. For example, in Dec. 2013 the SEC entered an “order instituting administrative cease-and-desist proceedings” against a Michigan company named Freedom One Investment Advisers, Inc. The SEC found, that among other violations, Freedom One had failed in its surprise inspection responsibilities.

“For all three years, Freedom One violated the Custody Rule because it took no action to determine whether the independent public accountants retained to conduct annual surprise exams to verify the assets over which it had custody performed those exams. For 2008, Freedom One engaged a national accounting firm to perform a surprise exam, but Accounting Firm 1 did not complete the exam. For 2009 and 2010, Freedom One engaged another national accounting firm (“Accounting Firm 2”) to conduct surprise exams, but the exams were insufficient because Freedom One told Accounting Firm 2 that only the IRA Accounts were subject to the exams and did not include the Managed Accounts.”

Part of Freedom One’s problem was that its CEO was also its chief compliance officer.

It’s the investment advisor’s responsibility to contract with an independent accounting firm to carry out the surprise inspection. That means no advance warning, no “hey, you’ll be seeing us soon,” or other tip-offs. The investment advisor, typically the chief compliance officer, is responsible for determining if a surprise examination is necessary under the rule. If it is, the examination must be conducted by an accountant registered and subject to inspection by the Public Company Accounting Oversight Board (PCAOB). The surprise inspection requirement exists unless,

“the advisor has custody solely because of its authority to deduct advisory fees from client accounts or it is an advisor to a pooled investment vehicle that is subject to an annual financial statement audit by an independent public accountant registered with, and subject to regular inspection by, the PCAOB and that distributes the audited financial statements to investors in the pool.”

Every aspect of the Custody Rule is useful to investors only to the extent they realize the protections, including the surprise examination, exist. Here are several things to consider if you are using, or plan to use, an investment advisor:

  1. Does your investment advisor meet the SEC-defined criteria for performing that role?
  2. What is the investment advisor’s track record with respect to Custody Rule compliance, and who is responsible for ensuring compliance?
  3. How will the investment advisor ensure the surprise inspection will be in place to verify your assets?

Knowing your rights, and the investment advisor’s responsibilities, goes a long way toward ensuring your peace of mind, protecting your investments, and keeping everyone involved happy – and out of trouble.


Tagged Featured, Financial, IRS, PCAOB, SEC, Securities and Exchange Commission, Assurance