March 8, 2013 / 4:11 PM / in 5 years

COMPLY-Advisers' failure to follow post-Madoff rule worries regulator

ARLINGTON, Va., March 8 (Reuters) - The failure by some advisers to follow a rule aimed at curbing their access to clients’ funds may be weakening efforts to prevent fraud, a top U.S. securities regulator said.

An investor risk alert announced by the Securities and Exchange Commission on Monday revealed that many advisers were not following mandatory procedures when they held client funds directly through their firms or when they could conduct certain transactions in customers’ accounts.

“It’s a big worry,” said Carlo di Florio, director of the SEC’s Office of Compliance, Inspections and Examinations, which regularly examines advisers to ensure they are complying with securities industry rules.

Lapses in advisers’ efforts to comply with the rule, which is aimed at curbing unfettered access to client funds, could make investors more vulnerable to fraud, di Florio told reporters on Thursday after speaking at the Investment Adviser Association’s compliance conference in Arlington, Virginia.

The SEC ramped up its “custody rule” in 2010 as a result of Bernard Madoff’s $65 billion Ponzi scheme.

While many advisers rely on outside companies, such as units of Charles Schwab Corp. and TD Ameritrade Holding Corp , to hold client assets, Madoff’s firm held his clients’ money in-house. That made it easier to conceal actions that an outside company may have uncovered, such as fabricating trades.

The custody rule changes include numerous safeguards, such as a requirement that outside custodians send quarterly account statements directly to clients, not just to the adviser.

But a recent review by the SEC showed some advisers did not know that they were deemed custodians. That is because they missed, or did not follow, some finer points of the rule.

Advisers, even when they park client assets with outside firms, are still deemed custodians by the SEC if they can access the funds through an online bill-paying service, or sign checks as trustees, among other actions.

Being labeled a custodian triggers other measures of the rule, such as being subject to surprise examinations. That means the adviser must hire an outside accountant whose role is to make unannounced inspections to verify that clients’ funds exist.

But the “surprise exam” requirement for certain advisers has led to other problems, the SEC said. Some advisers, for example, scheduled the exams so that they were not a surprise at all.

“The rule is there to say that if you don’t have these controls in place, the risk that customer assets will be lost is greater,” di Florio told reporters.


The SEC’s analysis was based on a review of recent examinations that contained “significant deficiencies,” according to the alert on Monday. About one-third of those - more than 140 - included custody problems. The SEC oversees about 11,000 investment advisers.

who violated the rule must now fix the problems, including developing new custody procedures at their firms, the SEC said. The SEC’s exam unit also referred some more-serious cases to SEC enforcement.

“I was surprised about the widespread number of deficiencies,” David Tittsworth, executive director of the Washington-based Investment Adviser Association, told Reuters. “At the minimum, we will have to do a better job about educating advisers about what their obligations are.”

Many advisers were confused by the custody rule requirements when they took effect in 2010. Some complained about not knowing whether they applied to their business situations.

The inability of some advisers to grasp whether they are even covered by the rule may result from both how the SEC drafted it and problems at the advisory firms themselves, di Florio said. The SEC may need to clarify the rule beyond a series of questions and answers from its staff published in 2010 and 2011, he added.

“Clearly people are struggling with the custody rule and different dimensions of the custody rule,” di Florio said in his remarks to compliance professionals.

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