SEC improves client safety, but investors must play a role

The name Madoff is synonymous with the recent financial crisis. The Bernie Madoff case, however, is one of several recent enforcement cases brought by the Securities and Exchange Commission (“SEC”) against investment advisory firms that had access to client assets and misused them.

Unlike Madoff, most advisory firms do not have physical custody of their clients’ assets. Rather, their clients’ assets are maintained by qualified and regulated third-party custodians like banks or broker-dealers. Clients receive one statement from their advisory firm and a separate statement from their custodial firm, creating a check and balance.

The SEC recently adopted new rules related to custody of client assets to help prevent Madoff-style incidents and to increase checks and balances in the industry. The new rules provide safeguards where there is a heightened potential for fraud by SEC-registered investment advisers. In addition, the new rules promote independent custody and require the use of independent public accountants registered with the Public Company Accounting Oversight Board.
Where an advisory firm has custody of client assets, the advisory firm is subject to annual surprise audits of the custodial accounts by an independent accounting firm. The surprise audit requirement verifies the client assets exist and provides another set of eyes on the client assets.
Where an advisory firm, or an affiliated bank or broker-dealer, has custody of client assets, the advisory firm must now obtain a written report of the custodian’s internal controls. The report, prepared by an independent accounting firm, also must describe tests of the effectiveness of the controls.
Where an advisory firm has custody solely because it has authority to deduct management fees from clients’ accounts, the surprise audit requirement does not apply. These advisory firms, however, must have a “reasonable belief” that the client’s custodian delivers account statements directly to the clients.
While the SEC’s new custody rules provide additional protection for investors, common sense and diligence remain essential. All investors should take steps to confirm the accuracy of their investment statements. Look for transparency, and seek out checks and balances.

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