July 27, 2009
Adopting a proposal to require surprise audits of investment advisory firms who custody client assets might be a reasonable precaution for the industry to take to prevent ponzi schemes that inflict a terrible toll on victims. However, the proposal's unintended consequences include raising barriers to entry in the hedge fund business (by raising the fixed cost of opening a fund), raising compliance costs and ultimately investor fees across the industry, and favoring large companies over smaller investment shops with no policy reason for doing so.
In addition, if the current definition of "custody" is allowed to stand, the impacts will be magnified dramatically and spread across thousands of investment advisors who already use third party custodians in order to provide independent pricing and safekeeping of assets to protect clients.
In 2002 when reviewing changes to 206(4)-2, fourteen commenters requested the Commission exclude advisers' authority to deduct fees from the definition of "custody". Eight commenters, including the ICAA and ICI, recommended that the Commission permit an adviser to deduct fees and make other withdrawals from clients' custody accounts without being deemed to have custody.
Five commenters requested clarification to distinguish an adviser's limited authority to move funds between a client's accounts or to a third party as specified by the client from an adviser's authority to withdraw funds for its own accounts. Advisors should be able to provide clients with "full service" without having to bear the burden of thousands of additional compliance costs for doing so.
There is little doubt that FINRA failed Maddox investors in executing its regulatory responsibility. The number of ponzi schemes being prosecuted shows that Maddox was not a unique situation. Many firms with no independent custodial reporting to clients are being investigated. However, the vast majority of advisors who have taken the precaution on behalf of clients to put in place independent custodians to safekeep client assets should not be driven out of business by mounting compliance costs. Nor should their ability to provide full service (help with transfers between accounts) be hindered without good reason.
Firms that custodied assets with major third party firms (e.g. Schwab, Fidelity, T.D. Waterhouse, etc...) have not been guilty of running these schemes, and it is hard to imagine the clients of these firms benefiting from these changes. Instead, they would see costs increase and choice among providers decrease, favoring big firms like Smith Barney/Morgan Stanley, Morgan Keagan, Merrill Lynch, and others who have failed investors in a multitude of ways (ARS, sub-prime debt issuance and sale to clients, etc...) during recent years.
Regulate. Effectively. But not to excess and only in substantive areas. That is what the industry needs from this revitalized SEC.