The High Cost of Regulation: How the SEC Plans to Untangle Your Assets

By: Paul_Petillo

By now, the Madoff name, synonymous with theft and deceit on a scale so grand that Ponzi would be envious, is known worldwide.  Although his actions (and those of his cohorts) did not trickle down to the vast majority of Americans, watching well-to-do people trust vast amounts of money to one person’s assurance and phony returns did not go unnoticed.

And although that wealth is gone for the most part, one thing remains certain, how it happened will force regulators such as the SEC to reexamine the rules that were bent into origami by Madoff’s scheme.  What is deeply problematic, and is at the heart of the SEC’s desire to change certain rules could be based almost solely on one statement.

Stephen Harbeck, President and CEO, SIPC, testified before the Senate Banking Committee on the subject of this fraud on January 27th of this year.  He suggested: “The prospect of stealing $10 million from a brokerage firm has only happened 10 times in 39 years. The regulators do a good job, generally speaking, of finding these kinds of actions." 

Do they?  Or is the tangled web of who holds what where, who is accountable, and just how much accounting for their client’s funds can be taken at the word of investment advisers and broker-dealers in need of repair? Securities Industry and Financial Markets Association doesn’t think so and in a letter to the SEC, gives the average investor a peek into why they object to any actions.

SIFMA, the lobby group for the securities industry seems to debunk what has happened to investors like those who believed in Madoff as incidental. 

At the heart of SIFMA’s objection is the cost of what the SEC is proposing.  The SEC wants to subject registered advisers, broker-dealers, custodians and everyone tangled in the massive web that investing has become (and to a lesser degree, what is your 401(k)) to a surprise audit.   The SEC suggests that this type of auditing would cost these entities about $8100.  SIFMA believes that it could rise to over a million dollars, calling the SEC’s estimation unrealistic.

Similar objections were raised when Sarbanes-Oxley was introduced following scandals at Enron and Worldcom.  But the world of accounting managed to drive those initial costs down significantly as it developed methods to do this monumental task that streamlined the process.  Members of SIFMA were surveyed about this proposal for surprise examinations and it was these members who offered their own cost of untangling the mess.

At the heart of the matter is who pays for what and are the protections that SIFMA believes are currently have in place, enough to satisfy the Commission and the investors who worry that they have no idea who or what has their hands in their accounts?  The SEC would like the chief compliance officer to step up and certify compliance with the SEC’s request.  SIFMA believes that the role of the CCO should be “to confirm that the adviser's compliance procedures regarding custody are reasonably designed and function appropriately. A CCO could, for example, review the adviser's reconciliation procedures, and compare the adviser's and custodian's records to client account statements” and they should not act as an accountant.

What the SEC wants can best be described as transparency.  The Commission has suggested that the purpose of the surprise examinations is an effort to “confirm with the custodian all cash and securities held by the custodian, including physical examination of securities if applicable" and to "reconcile all such [assets] to the books and records of client accounts maintained by the adviser, and (ii) verify the books and records of client accounts maintained by the adviser by examining the security records and transactions since the last examination and by confirming with clients [emphasis added] all funds and securities in client accounts."

SIFMA points out the 100% examination may not be possible.  Rule or no rule, the organization points out that “an accountant seeking to verify these assets must contact each issuer; if a single issuer is uncooperative or dilatory, the surprise examination may be delayed or even left incomplete.”  Does this suggest stronger wording to force compliance, fines or both for those proving uncooperative?

The confirmation of all assets should not be that difficult.  Except that in many instances, numerous parties handle these assets.  This dilution of blame and accountability is what the SEC wants to improve.  SIFMA seems to want business as usual and let the markets and the investors take of itself.

In a comment letter to the Commission, SIFMA asks what would happen if the adviser had no access to custodial rights?  Does advice obligate them to have the same descriptive powers as the custodian does, simply for their role as a client’s adviser?  There are affiliations to consider between the adviser, the custodian and sometimes the broker-dealer.  It is this web of interactive handling of a client’s assets that presents the biggest challenge for SIFMA to rebut.

The SEC would like to untangle this by forcing advisers to independent custodians. To unwrap these wrap clients would incur costs but in the end offer an additional layer of assurance for those interested in retaining as much control with as few hands collecting fees for the service.

In light of the billions of dollars lost by investors over the last several years and the role the financial industry played in keeping that money safe, the SEC is on the right track to improve the standards of accounting, the accountability of the numerous parties involved and by giving them notice that business as usual will not be the best way to conduct business moving forward, it is doing the job they were supposed to do. 

As I said, the cost of a surprise examination and a fully completed one will have costs.  But those will go down as these wrapped accounts find a way to streamline their management efforts.  One of the possible results of these types of rules will be less hidden fees, with less hand in the client’s assets. 

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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