What is the purpose of surprise examinations?
The bulk of the amended custody rule focuses on the reinstitution of surprise examinations for all registered investment advisers who are deemed to have custody of assets, and this is the piece that is causing heartburn in the investment advisory arena because it’s one of the costliest pieces of this reform.
Those who are using a qualified custodian and serve as a trustee or have general power of attorney over client assets are required to hire an independent accountant at least once a calendar year to perform a surprise examination. The bottom-line objective is to make sure that those client funds are where they are supposed to be and in the correct amount.
The accountant will obtain the records of the registered investment adviser and perform a sample inspection to confirm with the qualified custodian that what is said to be in the client accounts is what’s actually there. The accountant will also sample clients to confirm that any trades, liquidations, purchases and amounts transferred have been done with their knowledge and that the ending balance is what they believe to be proper.
How does this increase investor protection?
Previously, if you think of the Madoff case, the information that was provided to clients in terms of account balances was not accurate. Now, if an adviser tries to misappropriate client funds, these new rules would allow for a timely detection of such theft. Of course, the hope is that the new rules deter advisers from attempting any such wrongdoing.
In a nutshell, the new custody rules force advisers to utilize a qualified custodian, the qualified custodians send account statements directly to the adviser’s clients, and an independent accountant then separately confirms balances.
How does the amendment reduce the burden on advisers?
Previously, the advisers had to send out account statements to clients. The burden is reduced because the qualified custodian needs to do that now. All the adviser has to do, based on due inquiry, is have the belief that those account statements are being sent to his or her clients. If advisers also want to send account statements to clients, they can, but they need to clearly mark in the correspondence that the client should compare that document with the statements sent by the qualified custodian. That requirement is to prevent advisers from sending something that is fictitious.
It’s a difficult balance to strike between protecting investors and not creating onerous costs that drive advisers out of business. No investment adviser is going to say this is a bad thing, but there has to be a balance between what’s economically feasible and sustainable and how you protect investors.
Brian Finnegan is a partner with Burr Pilger Mayer. Reach him at (415) 288-6249 or [email protected].
