Smaller firms smacked by increased costs from audits, uncertainty over rule; 'this is a mess'
Blame it on Bernie.
A year after the implementation of new custody rules in the wake of Bernard Madoff's infamous fraud, some small advisory firms say that the cost of the surprise independent audits required to comply with the rule is killing them.
“The unintended consequences of the rule will affect clients, who will lose some important services or have to pay more for them,” said Susan John, an adviser with Financial Focus Inc. and chairman of the National Association of Personal Financial Advisors. “There is a great deal of confusion over what causes an adviser to have custody.”
Last month, Ms. John's firm paid nearly $7,000 for an auditor to conduct a surprise audit. She is trustee of less than $1 million in assets that were set aside by a longtime client to pay for the care of a child with special needs. .
“They made me the trustee because they knew I would take care of their child, but now the cost of complying is more than the fees we're charging to provide the service,” Ms. John said. “But I feel I owe it to the [deceased] client to continue as trustee.”
Not everyone is willing to shoulder the additional costs — especially when those costs are incurred for providing what they consider incidental services.
For example, the rule also applies to financial advisers who forward checks and securities on their clients' behalf to custodians. It also would apply to those who use their clients' passwords to make direct deposits of quarterly taxes to the Internal Revenue Service or even monthly payments to the client's mother-in-law.
“For many advisers, this means getting out of that line of service,” said Steven Stone, a partner with Morgan, Lewis & Bockius LLP. “The reality is this is a mess. The [SEC] guidance doesn't reflect the real world.”
The Securities and Exchange Commission approved the custody rule changes in December 2009 in reaction to Mr. Madoff's Ponzi scheme and several other cases in which advisers misappropriated client assets maintained by an independent custodian.
“When an adviser takes on the privilege and responsibility of having unfettered access to a client's money,” there is the need “to have an auditor's second set of eyes to confirm that those assets are safe,” SEC Chairman Mary Schapiro said in approving the rule, which took effect last March.
At that time, the SEC estimated that about 1,669 advisory firms would be forced to undergo new examinations. Those cost of complying with the rule would range from $10,000 to $125,000 a year, depending on the size of the firm, the SEC said.
Concerns about costs — especially for small firms — were voiced as the rule change was being debated.
Due to those concerns, the SEC agreed to review the first year's examinations to better determine the rule's effects on small advisers and their clients.
SEC senior counsel Melissa Roverts told several hundred advisers atending a compliance seminar in Arlington, Va., today that the review of the costs “is among the items staff is conducting a study on.” She said “it's too early” to say what the results of the study will conclude.
The rule will have been in place for one year as of Saturday.
The SEC has its “hands full” right now with multiple studies and new rules required by the Frank-Dodd financial reform act, so it isn't likely to look at the impact of the custody rule on small advisers any time soon, according to Skip Schweiss, managing director of TD Ameritrade Institutional.
“I don't know where this will fall,” he said.
Karen Barr, general counsel of the Investment Advisers Association, which sponsored the compliance meeting at which Ms. Roverts spoke today, asked the audience to indicate whether they had to undergo the surprise audit this year because they or their an employee serves as a trustee for a client. At least one third raised their hands and about four or five indicated they had passed on the costs of the exam to their clients.
Small firms have to judge for themselves whether it is worthwhile to provide a service that may “put the adviser in a difficult position,” Mr. Schweiss said.
A $10,000 bill for the examination is quite “a whammy” to a firm with $100,000 in revenue, he said.
For a firm with $1 million in revenue, it represents a 1% hit, Mr. Schweiss said.
State regulators, which oversee advisers with $25 million to $100 million in assets, are in the process of finalizing their custody rules to bring them into harmony with the federal changes.
Joseph Brady, deputy general counsel for the North American Securities Administrators Association, said its proposed rules don't try to address the difficulties that advisers have encountered with the federal rule.
“You have to make some choices when you make these rules,” he said. “There must be some safeguards for investors.”
