Comment Letter Financial Planning Association

Suite 201
1600 K Street
Washington, D.C. 20006
Voice: 202.449.6340
800.322.4237
Fax: 202.449.6350
E-mail: [email protected]
Web site: www.fpanet.org

July 28, 2009

Elizabeth M. Murphy
Secretary
Securities and Exchange Commission
100 F Street, N.E.
Washington, D.C. 20549-1090
Re: Release No. IA-2876; File No. S7-09-09
Dear Ms. Murphy:
The Financial Planning Association (“FPA®)1 appreciates the opportunity to comment on
the proposed rule (the “proposal” or “rule”) entitled “Custody of Funds or Securities of Clients by
Investment Advisers.” Financial planners are commonly regulated as investment advisers by
the Securities and Exchange Commission (“SEC” or “Commission”) and under state securities
laws. As a strong advocate of a fiduciary standard for financial planning services,2 FPA is
supportive of rules that benefit the public and enhance investor protection, particularly in a time
of financial crisis that has led to widespread loss of investor confidence in the capital markets.
Our detailed comments follow below.
I. Introduction
For obvious reasons, custody of client assets has always been a primary concern of
regulators. With respect to the billions of dollars in investor losses through Ponzi schemes that
have come to light recently – most notably those involving Bernard Madoff and Allen Stanford –
the Commission‟s renewed focus on custody is timely and appropriate. As noted in
congressional hearings, however, many of these frauds were uncovered largely as a result of
the severe market correction, not by regulators. This, then, becomes a question of how to
revise current regulatory or enforcement priorities, including an analysis of available resources,
to reduce future systemic fraud.
The crux of the matter was aptly summarized by a witness in a Senate Banking
Committee hearing:
1

The Financial Planning Association is the largest organization in the United States representing financial
planners and affiliated firms, with more than 25,000 individual members. FPA members directly manage
more than $1.75 trillion in assets with a combined client base of 3 million. Approximately 48 percent of
FPA members are affiliated with SEC-registered investment adviser firms and 24 percent with firms
registered on the state level. FPA is incorporated in Washington, D.C., with administrative headquarters
in Denver.
2

See FPA Standard of Care, at http://www.fpanet.org/AboutFPA/Organization/CoreBeliefs/.

DENVER · WASHINGTON, D.C.

The tide has gone out on Wall Street, and in Warren Buffet‟s words, we are now finding
out “who has been swimming naked.” Sadly, it has been the recurrent pattern in Ponzi
schemes and similar investment frauds, that they are revealed not by regulatory detection
and enforcement, but by their own collapse under the pressure of investor demands for
redemption when the market sours (and investors become belatedly anxious).3

This ebbing tide has led to questions from Congress about the efficacy of the current
regulatory system. With more than 75 Ponzi frauds uncovered in the past two years, 4 Rule
206(4)-2 of the Investment Advisers Act of 1940, commonly known as the custody rule, is now
under intensive analysis by the Commission.
In its comprehensive review5 of the rule seven years ago, the SEC added a broad
definition of “custody” and attempted to clear up the clutter of numerous staff interpretations built
up over 40 years. FPA was generally supportive of the rule changes in 2002. Today, we
strongly support continued review of the rule in light of these new, disturbing threats to investor
protection. At the same time, the concerns that we expressed with the interpretation of
“custody” under the 2002 rule, and in a more recent letter to the Commission regarding
protections provided through independent custodians,6 has led to what we believe is a major
flaw in the current proposal. We address these concerns, and also review other actions that
may be taken by the Commission to ultimately resolve the problem at hand.
In light of these possibilities, we believe adoption of the proposal is premature. The SEC
should await review of the Inspector General‟s report on Madoff and subsequent oversight
hearings of Congress prior to taking final action. For the same reasons, if the SEC moves
forward to adopt the amendments as proposed, the rule should be temporary, given the
likelihood of other reform measures to be passed by Congress affecting securities regulation
and the custody rule. In the interim, we believe that „down the chain‟ sweeps of custody
activities of investment advisers should continue and this, along with other measures taken by
the Commission, will help safeguard investor assets and restore confidence in the advisory
profession while a more comprehensive solution is found.
The main issues covered in our comments:
a. Independent verification of client funds and securities.7 FPA believes that advisers
deemed to hold custody solely by limited authority to deduct fees 8 should be excepted
3

Testimony of John C. Coffee, Columbia University law professor, Jan. 27, 2009, before the U.S. Senate
Committee on Banking, Housing and Urban Affairs, at 1.
4

Testimony of SEC Commissioner Elisse B. Walter “Concerning Securities Law Enforcement in the
Current Crisis,” before the U.S. House Committee on Financial Services, March 20, 2009.
5

Release No. IA-2044; File No. S7-28-02, “Custody of Funds or Securities of Clients by Investment
Advisers,” July 18, 2002.
6

See letter regarding custody issues, from Daniel Barry, FPA Director of Government Relations, to SEC
Chairman Mary L. Schapiro, Apr. 30, 2009, at 2.
7

Release No. IA-2876; File No. S7-09-09, “Custody of Funds or Securities of Clients by Investment
Advisers,” May 20, 2009, proposed sec. 206(4)-2(a)(4).
8

For ease of reference, we divide custody activities into two different categories: 1) „technical custody,‟
meaning an adviser meets the SEC definition of custody solely by having authority to deduct fees; and 2)
„physical custody,‟ in which the adviser has actual possession of client assets.

2

from the proposed requirement. We provide cost estimates that question the SEC‟s
assumption, and offer reasons why other actions of the Commission might do more in
accomplishing the overall goal of curbing Ponzi fraud.
b. Auditor integrity. We review action taken by the SEC and Public Company Accounting
Oversight Board (“PCAOB”) since the Madoff scandal and suggest why strengthening
the inspection requirements for PCAOB registrants, as well as requiring independent
verification only for certain advisers that maintain physical custody of client assets, may
be the most important actions undertaken by Congress and the SEC to mitigate this
problem.
c. Resources. Congress and the SEC are in agreement that additional resources are
needed for enforcement and may very well be the root cause of the problem. We urge
the Commission to wait before adopting a final rule until after it has carefully examined
the Inspector General‟s report on Madoff and then determined whether it is primarily an
enforcement and resource – not rulemaking – issue.
II. Background.
a. Historically, the Commission has sought to avoid additional burdens on
advisers deducting fees through custodial arrangements.
FPA encourages the SEC to maintain a consistent policy for advisers with
technical custody absent systemic fraud or abuse.
Under the current Rule, an adviser is generally deemed to have custody of client
assets when holding actual possession (“physical custody”) or having the authority to
obtain possession of some or all of the assets (e.g., by deducting advisory fees or
withdrawing funds on behalf of the client – “technical custody”). During previous
rulemakings, the Commission did not express much concern with technical custody in
contemplating investor risk. In fact, for decades it allowed advisers to rely on several noaction letters to deduct fees in this manner without being subject to the surprise
examination requirement. Had such activities posed significant risk to investors then,
the Commission would have undoubtedly addressed this problem. Instead, as noted in
the 2002 proposing release concerning deduction of fees, the Commission appropriately
expressed concern with unnecessary compliance costs:
We have designed the proposed rule so that these advisers would be able to
comply with the rule without facing the burdens they previously sought to avoid.9

The final rule retained this semi-exclusion from the custody requirement.
Perhaps initially puzzling to anyone who reviews the instructions to Form ADV, this
„semi-exclusion‟ comes from a requirement under Item 9, Part 1, that firms deducting
fees in this manner not check the „custody‟ box, even though the Commission believes
fee deductions to be a custodial activity. This seemingly contrary instruction suggests

9

Release No. IA-2044.

3

that the SEC has always viewed fee deductions as a low-risk activity, one not even
requiring notification to clients on Part II of the form as a potential conflict of interest.10
b. Madoff and other publicized Ponzi schemes have caused the Commission to
respond prematurely to demands for action.
FPA encourages the SEC to delay taking action until it has reviewed the Inspector
General’s report and considered subsequent recommendations by Congress.
Numerous Ponzi schemes were uncovered in the past year, even though such
fraud has been perpetrated on the public for decades through various real estate and
investment schemes. Of course, the sheer scope and size of the most recent ones have
gripped the attention of the American public and Congress. As noted earlier, many
appeared to have collapsed as a result of the market crisis rather than from vigilant
enforcement activity. Most notable among these lapses, and the subject of extensive
congressional review, is Madoff Securities.11
Clearly, Congress has placed pressure on the SEC to act decisively as a result of
the Madoff case, even while not providing specific guidance. This is, of course, how
congressional oversight works. It is ultimately up to the agency to revise policy if current
programs fail. In several hearings this year on Madoff, most of the focus was on
mistakes in enforcement, not regulatory gaps. Senate Banking Committee Chairman
Christopher Dodd, in his opening statement at the initial Senate hearing, said:
“…This much we know. Since Bernard L. Madoff Investment Securities LLC
started in 1960, the firm has been subject to examination and oversight by the
Securities and Exchange Commission and by the securities industry selfregulatory organization, the Financial Industry Regulatory Authority, or FINRA,
and its predecessor, the NASD.”
“…How could regulators have missed so many warning signs? Did the
examination staffs lack adequate expertise or numbers? Were they intimidated
by Mr. Madoff‟s influence in the securities industry? Did they lack legal authority?
Or, as I suspect, are there deeper problems?”[emphasis added]12

Indeed, we believe the problems are much deeper, and we believe the
Commission would agree that these problems cannot be resolved merely by
recalibrating a single rule. The SEC, under Chairman Mary Schapiro‟s leadership, has
responded with a number of initiatives, including more aggressive enforcement,
elimination of pilot penalty programs, organizational restructuring, and strengthening its

10

Part 1 is essentially a data collection section of Form ADV and is not required to be offered or
delivered to clients of an investment adviser. Part II is the standard disclosure section that is given to
prospective clients.
11

In the matter of Bernard L. Madoff and Bernard L. Madoff Investment Securities, L.L.C., 08 Civ. 10791
(LLA), (S.D.N.Y. 2008)
12

Opening statement of Senator Christopher Dodd, Jan. 27, 2009, hearing of the Senate Committee on
Banking, Housing, and Urban Affairs.

4

oversight and consumer tips and complaints programs.13 It is important to note that
Congress did not specifically ask the Commission to target advisers who deduct fees
through their custodians. Statements made in the relevant committees suggest a keen
interest in reviewing the report from the Inspector General and in exploring a broad set
of issues related to the inquiry. Consistent with this approach, we believe the SEC
should consider, and continue to implement other, more tangible solutions before
moving forward with a new requirement based on a vague nexus between advisers
holding technical and physical custody.
III. Independent verification of client funds and securities.
FPA urges the Commission to except advisers from the surprise examination
requirement solely as a result of authority to deduct fees.
As noted earlier, the SEC historically treated advisor accounts subject to
technical custody, i.e., the adviser is able only to withdraw advisory fees, in a completely
different manner than an investment adviser with physical custody (e.g., Madoff,
Sanford). There are a number of valid public policy reasons why technical custody
should be excepted from a surprise examination requirement.
a.

Ponzi fraud requires physical custody, not fee deductions, to operate.
According to commonly accepted definitions,14 a Ponzi scheme typically pays
returns to investors out of money paid by subsequent investors rather than from
profits. The system is destined to collapse because the earnings, if any, are less
than the payments.15
In a classic Ponzi scheme, even with small-scale frauds, adequate cash
inflow is required to cover payments to current investors. This may seem obvious,
but in order to make the fraud worthwhile to the perpetrator, he must be able to
siphon off substantial assets in addition to payments. If the fraud relies on fees that
are deducted from the corpus over a long period of time, without immediate receipt of
the entire investment, then such a scheme is far less appealing to the Ponzi artist. In
summary, this kind of cash-flow arrangement would appear to leave little or no
capital available for both distribution payments and theft.
The SEC this past spring testified before the House Committee on Financial
Services and reported on enforcement activity related to Ponzi schemes.16 To our
knowledge, none of the public statements or reports of the Commission to-date have
addressed the different risks between physical and technical custody, or abuses
related to fee deductions. If fee deductions were a common artifice used to foment
Ponzi schemes, we would expect the SEC to readily explain the connection.

13

“Testimony Concerning SEC Oversight: Current State and Agenda,” by Chairman Mary Schapiro,
before the U.S. House of Representatives, Subcommittee on Capital Markets, Insurance and
Government-Sponsored Enterprises, July 14, 2009.
14

See, e.g., http://en.m.wikipedia.com/wiki?search=ponzi+scheme;
http://dictionary.reference.com/browse/Ponzi%20scheme.
15

Wikipedia.

16

Testimony of Elisse Walter, March 20, 2009.

5

Regrettably, the Commission has not made a convincing argument in the
rulemaking or other public statements to justify applying a blanket requirement to
advisers who maintain some form of custody. Instead, the proposing release simply
states that “investment advisers typically do not maintain physical custody [emphasis
added] of client funds or securities but rather may [emphasis] have custody because
they have the authority to obtain client assets, such as by deducting fees from a
client account…”17 Later, it notes that “the surprise examination requirement of the
rule may deter fraudulent activities by advisers,”18 but it again fails to explain what it
means by “misuse” of client funds, and why a costly new requirement is needed for
advisers without physical custody.
In practical, not technical terms, there is a clear difference. Physical custody
means the ability to walk away with most of the funds. Technical custody, as we
define it, means that in practice, a dishonest adviser may walk away with 3 percent
of the client‟s funds per year, if he overcharges for his services. There are
safeguards in place that we discuss, limiting the ability to do even that.
We can only conjecture that, given the intense congressional scrutiny of the
Commission‟s enforcement activity, the SEC has determined to respond with a
sweeping regulatory response to assure Congress it is serious. However, absent
any abusive or fraudulent practices in the area of technical custody, we urge the
SEC to maintain the current exception while continuing to look at other, more
effective programs that demonstrate a renewed commitment to investor protection.
b. Protections are already in place with fee deduction practices.
Although not required by rule, most advisers that automatically deduct fees
send invoices directly to clients with a cost breakdown of various services provided.
In offering financial planning services in addition to portfolio management, the
investment adviser may break out the additional costs in the billing statement if such
services are not offset by the asset management fee. The client is then able to
compare the adviser‟s statement and billing costs deducted from assets with the
statement from the custodian. Statements are typically distributed monthly or
quarterly. In either event, the client has an opportunity to spot discrepancies more
often than would happen with an annual accounting review.
c. Qualified custodians offer additional protections for fee deduction accounts.
Third-party custodians typically have control procedures in place to detect
unusual fee deductions by the investment adviser. Like independent advisers using
third-party custodians, individual advisers affiliated with broker-dealers that serve as
qualified custodians, who may be considered higher risks by regulators since the
individual may operate in a branch office hundreds of miles from the corporate office,
are subject to similar controls. In both instances, the qualified custodian generally
would have copies of the client-adviser agreement that outline compensation
arrangements and the power of attorney that permits fee distributions by the
custodian.

17

Release No. IA-2876, at 3-4.

18

Id. at 71.

6

More importantly, the custodian also typically maintains control procedures to
identify unusual activity, such as excessive fee deductions or more frequent billings.
Unusual activity in the billing account would trigger an exception report that requires
a manual override by the custodian before processing the new fee deduction.
Typically third-party custodians will impose a 3 percent maximum cap on fees that
may be charged by the adviser per billing cycle, raising another warning flag if the
adviser attempts to exceed that amount.
In this manner, abusive practices are mitigated by internal controls of the
custodian, separate from the periodic statements that enable the client to review any
billing or other discrepancies.
d. Questions around the estimated cost of a surprise examination.
The proposing release relies heavily on a 2002 cost estimate of $8,000 per
firm19 in concluding that the average surprise examination today would cost about
the same. The 2002 analysis was based on the average firm having 670 clients
subject to the exam. The current proposal, however, estimates 978 clients in today‟s
typical firm, yet the estimated exam fee is only slightly higher.20 Nor does the current
proposal build in an increase for inflation. These assumptions are at odds with what
accounting firms tell us about current costs. As a general rule, the greater the
number of client accounts that need to be inspected, the more expensive the billing
or fee arrangement. Such an exam is not scalable based on size.
The proposing release also states that the SEC consulted with “a few
accounting firms” to confirm that the old costs were consistent with the new
requirements. In discussions with a number of firms, however, FPA questions the
accuracy of those estimates. Indeed, we believe that the true cost of the average
examination could be up to three times higher than the SEC‟s finding, or a minimum
range of $15,000 to $24,000 in average costs.
Given these discrepancies, we believe the SEC should review the disparity and
consider why the most critical factor in cost – the increase in client numbers from 670
to 978, or nearly 50 percent – does not change the overall cost of the surprise
examination.
Secondly, neither the 2002 or 2009 analysis appears to take into account
significant variables that can affect the overall cost of the examination. Key variables
include multiple accounts for each client, type of investment that must be counted
individually (e.g. securities versus mutual funds), and number of custodians.
Using our own membership data in combination with IARD data for
comparison, FPA came up with different costs. Each individual FPA member, for
example, has an average of 200 clients. Using the SEC‟s estimate from IARD data
that 85 percent of a firm‟s clients have discretionary accounts in which fee
deductions are made, each FPA member would have 170 clients subject to the
surprise examination. (85% X 200 = 170.) To this we added three accounts per
19

Release No. IA-2044, footnote 72.

20

Release No. IA-2876, at 42.

7

client, or a total of 510 accounts that must be inspected. 21 Although firm
demographics vary considerably, on average each FPA firm has only one principal
maintaining client relationships. Therefore we treated each planner as a firm. This
resulted in a client base only about one-fifth the size of the average SEC firm. (170
X 928 divided by 100 = 18.3 %.)
One might initially conclude that the examination cost for each FPA firm would
be substantially less than the SEC average. Based on this assumption, an FPA firm
audit would cost about $1,500, compared to the $8,100 SEC average (18.3% X
$8,100 = $1,482.30). However, our accounting firms rejected this assumption as far
too low. One believed there would be a minimum floor, or base cost of
approximately $4-5,000 for any surprise examination -- even if the adviser had only
four or five clients. The reasons cited were different technical requirements related
to a surprise examination: applicable attestation standards of the American Institute
of Certified Public Accountants, each firm‟s quality control procedures, and any
future requirements instituted by the SEC, PCAOB, or any other governing body.
This explanation, we believe, also contrasts with another cost assumption from
the 2002 proposing release – that a surprise examination of 1 percent of a firm‟s
clients would cost only $1,000.22
Using a client base of 170 clients for one adviser and other assumptions cited
above, one of our practitioners received the following estimates23 from three
accounting firms located in North Carolina:
$18-20,000 (an estimate from a CPA firm used by the adviser)
$10-12,000 (by an auditor of non-profit organizations)
$15,000 (by another CPA firm)
Taking the average of the three, the cost per examination of a financial planner
with 170 clients would be $15,000. ($19,000 + $11,000 + $15,000 by 3 = $15,000.)

21

We believe this to be a conservative estimate. FPA‟s volunteer committee of practitioners suggested
that their clients often have five and sometimes up to 10 accounts for which the planner charges a
consolidated management fee. One example was for a married couple with two traditional and two Roth
IRAs, two 401(k) plan accounts, a joint brokerage and a joint trust, the sum total being eight accounts for
one client.
22

See 2009 proposing release at 64: “[Under the current rule]…11 advisers were subject to the surprise
examination with respect to 100 percent of their clients and spent $8,000 each annually, on average, and
193 advisers were subject to the surprise examination with respect to only 1 percent of their clients and
spent $1,000 each annually, on average.
23

The scope of the examination provided to accounting firms was based on the SEC‟s criteria described
in the proposing release on page 6: 1) Confirm with the custodian all cash and securities held by the
custodian, including physical examination of securities if applicable; 2) Reconcile all cash and securities
to the books and records maintained by the adviser; 3) Verify books and records of the adviser for these
accounts by reviewing all transactions since the last examination; 4) Confirm with clients all funds and
securities in the accounts; and 5) Confirm with clients, on a test basis, closed accounts or assets returned
to them since the last examination.

8

FPA also discussed the examination cost with a Cleveland accounting firm
(registered with and inspected by the PCAOB) that conducts audits and
examinations of broker-dealers, mutual funds, and small advisers. Its estimate was
much higher than the other firms. In this instance, the Cleveland firm cited a real
example – a small adviser with 100 clients, of whom there were about 150 accounts
spread out among 10 different custodians. The Cleveland firm charged a fixed
engagement fee of $12,000, although it subsequently found it had underestimated
the true cost. In billable hours, the real cost would have been closer to $20,000.
This was due to, among other things, limited cooperation and lack of confirmation
responses received from the custodians and clients; the volume of routine
reconciling items noted (i.e., trade date vs. settlement date) which must be
investigated; and changes in the volume of investments held within each client
account from the time the fee quote was provided to the date of the surprise
examination.
When asked what the firm would charge based on the SEC‟s average client
based of 928, the Cleveland firm indicated at least $24,000, or nearly three times the
SEC‟s estimate.
Separately, two compliance firms that work with advisory clients around the
country, one with offices on both coasts, the other in the Midwest, provided similar
estimates of $10-20,000 for a surprise examination.
Another factor not addressed by the proposing release is the effect on supply
and demand for accounting work generated by Sarbanes-Oxley after the 2002
custody rule amendments were adopted. With the SEC estimating an additional
9,385 advisory firms suddenly required to undergo surprise examinations, accounting
firms may charge even higher prices due to the increased demand.
In summary, it is clear that costs for surprise examinations of this sort will vary
considerably, depending upon a variety of factors. While FPA‟s survey was limited in
scope, so were the estimates in the proposing release. At an absolute minimum, we
believe more extensive work must be done by the Commission in estimating a
realistic average cost per firm. However, based on our own analysis and other
comments we‟ve seen filed by individual practitioners on the rulemaking,24 we
believe that the true costs are likely to be significantly higher than the SEC‟s original
estimates.
Taking into account all of the above factors, we believe that the SEC‟s average
estimate is too low: possibly by half or more.
e. Accounting firms not readily accessible in rural areas.
Although many investment advisers are located in metropolitan areas where
their clients live, some advisers live and work in rural areas. Related to our concerns
with the examination costs enumerated above, we would add to this list fees charged
for „drive‟ or travel time of the accountant. We note that this concern has also been
raised by other commenters.
24

See, e.g., comments of Jeffrey W. McClure to the SEC, June 22, 2009, $15-20,000 estimate; Dennis
Vogt, July 2, 2009, $10-12,000 estimate.

9

f. The rule will ultimately affect state-registered investment advisers.
While this rulemaking would directly affect only federally registered investment
advisers, we are aware that the SEC has worked cooperatively with state securities
regulators and others over the years to harmonize rules and enforcement activity.
We believe that a final rule would ultimately impact state-registered investment
advisers (“RIA”), as well.
After adoption of the 2002 amendments to the SEC Rule, the North American
Securities Administrators Association (“NASAA”) proceeded to make similar
amendments to its model rule.25 We believe that the states would again follow the
SEC‟s lead if the current proposal were adopted.
The fiscal impact on state RIAs would be even more severe, since state RIAs
typically have a smaller asset base and less diversified income stream.
g. Proposed independent examination is anti-competitive.
Finally, the rulemaking does not distinguish between the proportionately higher
compliance costs for smaller advisory firms, e.g., those with assets under
management of $25 million to $100 million, and those with billions under
management. It is certainly much easier to absorb compliance costs for larger firms.
Yet under the Regulatory Flexibility Act, the SEC does not analyze the disadvantage
for smaller advisers with the exception of a handful of firms allowed to register with
the SEC having less than $25 million in assets under management.26 The proposing
release simply states that “…no more than 8 of these [small] advisers or their related
persons would serve as a qualified custodian for client funds or securities under the
proposed rule…” The Commission also rejected easing compliance requirements for
smaller firms27 and did not comment on the relative costs to smaller firms in terms of
effects on competition, other than to state that “we believe that the proposed
amendment would not materially increase the compliance burden on advisers...”28
We disagree. Based on FPA‟s own internal study,29 eight in 10 planning firms
with less than $50 million under management generated less than $500,000 in gross
25

See “NASAA Custody Requirements for Investment Advisers, Model Rule 102(e)(1)-1,” Adopted April
3, 2000, Amended 4/18/04, 9/11/0, http://www.nasaa.org/content/Files/IACustodyRules.pdf.
26

Release No. IA-2876, at 73.

27

“We do not believe that differing compliance or reporting requirements or an exemption from coverage
of the rule amendments…would be appropriate or consistent with investor protection.” Id.at 75.
28

Id. at 78.

29

Source: “2009 FPA Financial Planner and Staff Salary Survey.” Data below shows assets under
management and correlation to annual gross revenue.
Assets Under Management
$0-$49.9 million
$50-$99.9 million
$100-$249.9 million
$250-$999.9 million
$1 billion or more

Percentage of FPA firms with >$500,000 revenue
83.9%
33.4%
6.4%
2.9%
0%

10

annual revenue, which must cover overhead, salary and benefits, debt, and other
expenses. Similar income levels are reported by one out of three firms with $50-100
million under management. According to IARD data, about half of all SEC-registered
advisers manage less than $100 million in assets,30 therefore it can be assumed that
4,000 or more SEC-registered advisers would be faced with significantly higher
compliance costs. Not surprisingly, the disparity in income between these smaller
firms and those with $100 million or more assets under management places the
smaller firms at a significant competitive disadvantage.
h. Alternatives.
FPA opposes the inspection requirement of advisers with technical custody as
costly and unnecessary. We offer other alternatives below.
In lieu of a surprise exam, we believe other alternatives would meet the
Commission‟s goal of strengthening custody rules.
First, it may consider imposing a requirement that all advisers provide clients
with a user-friendly breakdown of fees in advance of the custodial statement. This
would work well with the proposed notice that advisers encourage clients to compare
statements.
Second, the Commission may want to require that advisers with fee deductions
provide the qualified custodian with a copy of the client compensation arrangement,
so it is aware of how fees are charged.
However, FPA is opposed to fee caps as a method of internal control. We
believe a rigid cap on overall compensation would not work as intended, particularly
if there were performance fee compensation arrangements. Other internal controls
discussed above would be preferable.
Finally, and notwithstanding what we believe are compelling reasons for the
SEC to except advisers with technical custody from surprise examinations, if the
Commission proceeds with this requirement, we ask that it consider reducing the
requirement for verification of all accounts to random verification.
By limiting random audits to 10 percent of an advisory firm‟s clients (about 93
clients),31 and perhaps a floor of 25 clients for firms that fall below that percentage,
we believe that the SEC could still accomplish its objective without compromising on
its overall goal of establishing independent verification. The accountant should be
left with the discretion to single out higher risk accounts for inspection, including
some of the largest accounts and accounts recently closed.
IV.

Auditor Integrity.
FPA believes strengthening rules and authority of PCAOB would enhance investor
protection more than any other regulatory initiative.

30

See “Evolution Revolution 2008, A Profile of the Investment Adviser Profession,” by National
Regulatory Services and Investment Adviser Association, chart C6, at 5.
31

10% X 928 = 92.8.

11

Madoff Securities in 2006 became a registered investment adviser allegedly
holding physical custody of client assets. As such, he was subject to a surprise
examination under the custody rule. When entering his guilty plea, Madoff admitted that
he “intentionally and falsely certified” that his advisory firm had custody of client assets.
Subsequent investigation by federal authorities revealed that the accounting firm
retained by Madoff for the annual surprise examination was nothing more than a shell
company. The SEC‟s complaint alleged that Madoff‟s accounting firm, Friehling and
Horowitz, accepted millions of dollars in fees and other payments while both exploited a
loophole that exempted it from registration or inspection by the PCAOB. This loophole
was created by a series of orders issued by the Commission in 2003, 2004, and 200532
that exempted privately-held broker-dealers like Madoff‟s firm from the requirement to
use a registered public accounting firm.
By shutting down this registration loophole after Madoff confessed, the
Commission may discourage future accounting frauds. However, registration alone is
not sufficient. By only closing the registration loophole, it is conceivable that the Madoff
scheme could still be going on today had the market not crashed. This is because
registration with PCAOB does not automatically allow it to inspect all of its registrants,
unless the firm is involved in examining public companies. However, this problem is
about to be addressed legislatively. As we understand it, the Commission is in fact
working closely with Congress to expand PCAOB‟s authority to not only register, but also
to inspect accounting firms that were previously exempt. We applaud this effort. It is
hoped that legislation such as H.R. 1212 will provide PCAOB with the tools it needs to
carefully examine all accounting firms within a three-year cycle and help avoid the kind
of phony surprise examination that Madoff used to avoid regulatory scrutiny.
V.

Resources.
FPA supports greater enforcement resources for the SEC.

As noted recently by SEC Chairman Schapiro in congressional testimony,33 the agency
is in great need of increased resources. Since fiscal year 2005, the SEC has faced three
consecutive years of flat or declining budgets, resulting in an overall 10 percent reduction in its
workforce. During the same period, the investment adviser registrations have increased nearly
30 percent, and since 1999, by 78 percent.34
According to reports, Madoff was only examined once after registering as an adviser in
2007. It is clear that the SEC needs more resources to do its job and get back to the annual
audit goal of once every five years for each adviser.
VI.

Other Issues.

FPA greatly appreciates the questions posed by the Commission on a number of
different matters. We touch on many of the key questions in our previous comments.
Additionally, we offer comment on other issues of concern to financial planners.
32

Securities Exchange Act Release No. 34-54920 (2006).

33

Testimony of SEC Chairman Mary L. Schapiro, July 14, 2009.

34

Id. and Evolution Revolution, 2008.

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a. Should [the SEC] require advisers to adopt compliance policies and
procedures administered by a chief compliance officer, and to submit a
certification to the agency on a periodic basis that all client assets are properly
protected?
No. FPA believes certification would not enhance investor protection, primarily
because if a firm were intent on committing fraud, it would fabricate its certification.
In practical terms, it would be difficult or impossible to certify assets held by a thirdparty custodian unless it undertook its own verification procedures that essentially
replicated aspects of the surprise examination.
b. Should [the SEC] deem an adviser to have custody if its related persons hold
assets in connection with the adviser’s advisory services?
The Commission proposes amending the rule to provide that an adviser has
custody if client assets are held by a „related person.‟ A related person is a person
directly or indirectly controlling or controlled by the adviser, or under common
control.35 FPA has concerns with the technical definition of „related persons.‟ We
are concerned that some financial planners, having organized state-chartered trust
companies to hold client assets, might come under the definition. In all instances,
their respective ownership in the trust company is typically less than 7 percent.
Some principals in the advisory firms, however, may serve as an office of the Board
of Directors of the trust company. Unofficial staff guidance from the SEC suggests
such activities, assuming a Director did not hold more than 25 percent of voting
rights, would not be deemed to control the entity. FPA wants to confirm that the
proposal would not inadvertently trigger such a requirement.
Second, with respect to related persons such as broker-dealers, we agree that
for purposes of custody, the dually registered adviser and broker-dealer (“dual
registrant”) should be deemed to hold physical custody.
c. Would the requirement of an internal control report by advisers with physical
custody provide additional protections for clients?
We believe an internal control report should not be required for dual registrants
or for advisers affiliated with bank and trust companies that maintain physical
custody. Broker-dealers and banking institutions are already subject to extensive
regulation and oversight with respect to protection of customer assets.
d. Does it make sense to require both an internal control report and a surprise
examination?
We believe both should be required only if the adviser holds physical custody
and is not a related person of a qualified custodian. Independent advisers using a
third-party custodian to deduct fees are not subject to the internal controls
requirement in the proposal and we believe should continue to be exempt. In
addition, FPA believes that dual registrants should not be excepted from the surprise
35

Release IA-2876, at 18.

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examination requirement if such a requirement were imposed on independent
advisers that use third-party custodians.
e. Should we simply amend rule 206(4)-2 to require that an independent qualified
custodian hold client assets?
No. FPA believes there are adequate safeguards in place for affiliated qualified
custodians. To make it a requirement for affiliates of an adviser to maintain custody
with a third party would significantly increase costs significantly for clients and raise a
host of other privacy and compliance issues.
f.

Delivery of account statements and notice to clients.
FPA supports the proposed amendments to require advisers with technical or
physical custody of client assets to have a “reasonable belief” through appropriate
due diligence to ensure that clients or their representatives are receiving account
statements from the qualified custodian.
Further, FPA supports the revisions to Part 1 of Form ADV to include a
statement to clients urging them to compare account statements that they receive
from the custodian with those from the adviser.

VII.

Conclusion
FPA appreciates this opportunity to provide comment on the critical investor
protection issues raised by this proposal. Please contact the undersigned at 202-4496341 for any questions or comment.

Very truly yours,

Duane Thompson
Managing Director, Washington Office

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