Surprise Audits and Other Reforms
The new reforms are all designed to protect investors who do business with investment advisers registered with the SEC. Investment advisers differ from banks and broker-dealers in that advisers frequently do not have physical custody of their clients’ funds or securities. This opens the door to abuses, such as those described in recent SEC enforcement actions in which advisers allegedly distributed false account statements showing non-existent funds.
To help protect investors from the heightened risk of fraud or theft associated with non-custody of assets, the SEC amended its “custody rule” to include the following requirements:
All custodians of client assets will need to send statements directly to advisory clients (investors), rather than through the investment adviser, and advisers will be required to instruct their clients to compare any account statements received from the custodian with those received from the adviser.
In most cases where a registered investment adviser does have custody of client assets, the adviser will be required to undergo an annual surprise exam by an independent public accountant to verify that the reported assets exist. These advisers will need to disclose the identity of the public accountant that performs its surprise exam and report the reasons for any changes in auditors. Under the final rule, the independent accountant must be registered with the PCAOB and the first examination must take place by December 31, 2010. Exceptions: Exceptions to the surprise audit requirement were made for: (1) advisers who have custody of client assets solely because of the adviser’s authority to deduct advisory fees from client accounts, and (2) advisers to pooled investment vehicles that are subject to an annual financial statement audit by an independent public accountant and that distribute the audited financial statements to the pool’s investors.
In cases where the adviser is reporting on assets and there is no independent report by an independent custodian, (e.g., the custodian is a related person), the investment adviser will be subject to a review that results in a SAS 70 report, i.e., a written report prepared by a PCAOB-registered and inspected accountant that describes the controls in place, tests the effectiveness of the controls and provides the results of these tests. These reports will need to meet standards set by the PCAOB. The first internal control report must be obtained by September 12, 2010 (six months from the effective date of the final rule.
To address concerns that the surprise exams are limited to annual exams, leaving the investor exposed to risks that can remain undetected for up to twelve months, the final rule provides Commission reporting requirements. Each investment adviser subject surprise audits must enter into a written agreement with an independent accountant that, among other things, requires the accountant to notify the Commission within one business day of any material discrepancy found during the course of the examination. The rule also establishes reporting requirements for dismissal or resignation of the accountant.
Additional Guidance for Independent Accountants
A companion release on “Commission Guidance Regarding Independent Public Accountant Engagements,” provides interpretive guidance for the independent accountants who perform the surprise audits. The guidance modernizes and clarifies the procedures to be performed, including confirmation of client funds with the custodian and the client and examination of the securities over which an investment adviser has custody.
Will the reforms prevent future Ponzi Schemes?
Only time will tell. As the SEC acknowledged in the final rule, no set of regulatory requirements will prevent all fraudulent activities by advisers or custodians. But these newly-established reforms will provide investors with greater protection and better information about the custodial practices of registered investment advisers.