REGULATORY UPDATE FOR INVESTMENT ADVISERS: The "New" Custody Rule, Changes
in SEC Registration, and a Harmonizing of the Fiduciary Duty Standard
Introduction - 5mins
There have been big changes occurring in the regulatory framework effecting all those offering financial
products and services. Recently, there has been the massive federal overhaul legislation that will move
into the rulemaking phase here shortly. Already through the rulemaking process are changes by the SEC
in the custody rules pertaining to client assets and securities by RIAs. I will cover with you today the
changes in the SEC's custody rules, the change in SEC registration for RIAs with less than $100 Million
AUM, and the possible change in the standard of care i.e. the fiduciary duty, being expanded to apply to
others than RIAs, specifically to broker-dealers.
Custody Rule- 20 mins
The final changes to the rules on the custody of client funds or securities by Investment Advisers
was promulgated in March 2010. These changes address the SEC's concerns over gaps in the prior rules
on the custody and maintaining of client assets and securities that were exposed in the Madoff scandal
and the numerous enforcement matters involving investment adviser Ponzi schemes following since. As
we know, Ponzi schemes necessarily rely on the falsification of account statements. To address gaps in
the existing rules that failed to detect these schemes the SEC promulgated these stronger accounting and
reporting rules for the custody of client assets by advisers.
Advisers With Custody
If the IA has custody over client funds the IA must now undergo an annual surprise examination
by an independent public accountant and receive from the accountant an "internal control" report
relating to the custody of the assets by the adviser (this however does not pertain to IAs that have
limited custody due to fee deduction authority). Moreover, Rule 206(4)-7 requires an adviser with
custody to adopt controls over access to client assets that are reasonably designed to prevent
misappropriation or misuse of client assets, develop systems or procedures to assure prompt
detection of any misuse, and take appropriate action when misuse is detected.
Advisers with custody of clients assets should consider policies and procedures that:
"1. conduct background and credit checks on employees of the adviser who will have
access (or could acquire access) to client assets to determine whether it would be
appropriate for those employees to have such access;
2. requiring the authorization of more than one employee before the movement of assets
within, and withdrawals or transfers from, a clients' account, as well as before changes to
account ownership information;
3. limiting the number of employees who are permitted to interact with custodians with
respect to client assets and rotating them on a periodic basis; and
4. if the adviser also serves as a qualified custodian for client assets, segregating the
duties of its advisory personnel from those of custodial personnel to make it difficult for
anyone person to misuse client assets without being detected."
Advisers should consider including in their policies and procedures a requirement that any
problems be brought to the immediate attention of the management ofthe adviser and develop
policies regarding the ability of individual employees to acquire custody of client assets.
Advisers Without Custody
For those clients whose assets are maintained by an independent custodian, the client must now
receive directly from the qualified custodian the account statements. The amended rule requires
that an adviser conduct a due inquiry to form a reasonable belief that the custodian sends account
statements directly to client. Therefore, the adviser's obligation under the rule is to conduct "due
inquiry" into the custodian's procedures of sending account statements to the clients.
How an Adviser might conduct due inquiry is not prescribed by the SEe but one suggestion is the
custodian provide the adviser with a copy if the account statement that was delivered to the client.
(The SEe rejected the position of some advisers that accessing account statements through a
website was not adequate to form a reasonable belief the statements were sent to the client, or that
the clients obtained statements through the website.)
Rule 206(4)-2 is amended to provide that when a custodial account is opened for the client the
adviser must include in the notice of the opening of the custodial account a legend urging clients
to compare the account statements they receive from the custodian with those they receive from
the adviser. And, ifthe adviser elects to send its own account statements to clients the legend
must be included in the adviser's statements.
Advisers With Custody Only to Deduct Fees
Advisers that have custody as a result of their authority to deduct advisory fees are not subject to
the surprise annual audit requirement. But, the SEC cautions that "Advisers that have custody as a
result of their authority to deduct advisory fees directly from client accounts held at a qualified
custodian should have policies and procedures in place that address the risk that the adviser could
deduct fees which the adviser is not entitled under the terms of the advisory contract, which
would violate the contract and which may constitute fraud under the Advisers Act. The adviser's
policies and procedures should take into account how and when clients will be billed, and be
reasonably designed to ensure that the amount of assets under management on which the fee is
billed is accurate and has been reconciled with the assets under management reflected on
statements of the client's qualified custodian."
Examples of policies and procedures that such an adviser should consider include:
1. periodic testing on a sample basis of fee calculations for client accounts to determine
their accuracy;
2. testing of the overall reasonableness of the amount of fees deducted from all client
accounts for a period of time based on the adviser's aggregate assets under
management; and
3. segregating duties between those personnel responsible for processing billing invoices
or listings offees due from clients that a provided to and used by custodians to deduct
fees from clients' accounts and those personnel responsible for reviewing the invoices
and listings for accuracy, as well as the employees responsible for reconciling those
invoices and listings with deposits of advisory fees by the custodians into the advisers'
proprietary bank account to confirm that accurate fee amounts were deducted.
Changes in Registration for Adviser Firms with Less Than $100 Million AUM - 10 mins
The recent federal legislation has a significant effect upon RIAs that were SEC registered with
less than $100 Million ADM. As a result of the passage of the Financial Reform Act, registration and
primary jurisdiction over investment advisers with $1 OOMor less under assets will now fall to the States.
This change was enthusiastically supported by the States to expand their enforcement authority. This
change is expected to affect thousands of investment adviser firms and will require these firms to
implement new registration procedures and review their compliance programs under the States' rules. The
RIA will now register with the States by filing the appropriate SADV -1 and accompanying documents
such as a certified financial statement and balance sheet. The SEC will promulgate forthcoming rules that
should address such things as any changes in ADV filing procedures, any grace periods an IA may have
to register, etc.
In Missouri, a firm is required to have a Qualifying Officer that meets a heightened exam
requirement. The Chief Compliance Officer requirement under the Investment Adviser Act of 1940 is not
contained in Missouri's statutes or rules. Rather in Missouri, the firm must have an Investment Qualifying
Officer who has passed the Series 7 and either the Series 65 or Series 66 examination with a score of
at least eighty percent (80%). The heightened exam requirement is not in the SEC's rules. And while
there are waivers to this examination requirement, this may be problematic for many firms converting
over. I'm sure the Missouri Securities Division will be looking at this in light of the expected influx of
newly registered firms and the conflict that exists in Missouri's rules with SEC's rules the firms were
previously operating under. In the meantime, if you are affected by this change you may want to call the
Division for help or seek the assistance of someone who can shepard you through the new filing
procedures for the states and advise you on other changes that your firm might be under besides
registration.
Anticipated Change in the Fiduciary Duty Standard - 20 mins.
Resulting from the recently passed federal legislation, the SEC has six months to study and report
to Congress on the effectiveness of the existing legal and regulatory standards of care~ and whether there
are gaps, shortcomings or overlaps in the legal or regulatory standards in the protection of retail
customers. In the study, the SEe is mandated to take into account thirteen separate considerations in its
study, among others;
•
•
whether retail customers understand the different standards;
is confused by them,
•
the difference in regulating BDs and !As;
•
•
the potential impact upon retail investors if the standard is adopted, or not: and
the added cost.
While the legislation doesn't impose any new duties on BDs right away or mandate any particular duty or
outcome, the legislation does already give the SEe the authority to establish a fiduciary duty for brokers
and dealer by providing the SEe may:
"promulgate rules to provide that with respect to a broker or dealer when providing personalized
investment advice about securities to a retail customer (and such other customers as the
Commission may be rule provide), the standard of conduct for such broker or dealer with respect
to such customer shall be the same as the standard of conduct applicable to an investment adviser
under the '40 Act."
We know the SEe must take into account thirteen separate considerations in their study but what we don't
know is the weight assigned to each consideration. The States have been aggressively lobbying for the
fiduciary duty to apply to everyone. (See NASAA President Denny Crawford's letter to Congress). As a
prior regulator, it is obvious to me the confusion surrounding the differences in the legal and regulatory
standards of care. Retail investors don't know the difference and those in the industry blur the lines
themselves. (Example of a letter from a Registered Representative that clearly offers investment advice.).
I predict you will see the SEe come to the conclusion that the fiduciary duty standard be expanded to
brokers and dealers.
Conclusion and Questions - Smins
We have big changes coming our way. Now, the massive overhaul of the regulatory financial system will
begin to evolve as the rulemaking begins. The focus now shifts from the legislative process to the 67
studies and more than 200 rulemakings authorized by the legislation. This is a crucial time, and where the
details are worked out by the regulators. Keeping informed of these proposed changes helps you stay
abreast of the impact these changes will have upon you and your firm.