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News February 2, 2009 Issue

Richards at Senate Banking Committee Hearing: SEC Considering Custody, Form ADV Changes

The Senate Banking Committee last week held a very interesting hearing, titled "Madoff Investment Securities Fraud: Regulatory and Oversight Concerns and the Need for Reform." Lori Richards, director of the SEC’s Office of Inspections and Examinations, was a key witness.

The hearing was long and covered much ground. Here are the items of particular interest to investment advisers:

Independent custodian requirement. Columbia University Law School Professor John Coffee began the hearing by testifying that the best way to prevent future Ponzi schemes is to require investment advisers and hedge funds to use independent custodians. Registered mutual funds, he noted, seemingly have been immune to Ponzi schemes. Coffee attributed that historical fact to the Investment Company Act’s requirement that registered funds use an independent custodian to hold investor funds. While an independent custodian will follow an adviser’s instructions to buy or sell securities, it will not remit the proceeds of those sales to the adviser or to anyone else, except when it fulfills shareholder redemption requests, he said

In contrast, when a firm acts as its own custodian, "I think you are violating the first rule of common sense," he said. "You cannot be your own watchdog." The Madoff fraud, he added, occurred because the SEC "gave us an illusory rule." That, of course, was a reference to the Advisers Act custody rule, which has long allowed advisers to use their broker-dealer affiliates (or themselves, if they are a dual registrant) as their custodian.

In Coffee’s view, the presence of an independent custodian essentially eliminates an adviser’s ability to conduct a Ponzi scheme. "Many and probably most hedge funds" already use an independent custodian as a matter of best practice, he said.

During the Q&A portion of the hearing, Committee Chairman Christopher Dodd (D-CT) asked OCIE director Richards whether there had been any debate within the SEC about requiring advisers to have an independent custodian. Richards did not directly answer his question about an internal debate, but replied that the SEC estimated that "as many as 1,000 investment advisers" currently have custody with an affiliated custodian, such as a bank or brokerage firm. "Unless the entity is truly independent, it gives the possibility of fraud," she continued. "So that is one of the changes that I hope that the Commission will strongly consider in the days ahead."

Dodd asked Richards if there were any downsides to an independent custodian requirement. She noted that it would impose additional costs on affected advisers. Dodd said he had little sympathy for that argument.

Richards then reiterated that she believed the Commission would study the independent custodian issue "very quickly in the coming days and weeks." Dodd, saying he was speaking for others on the Senate Banking Committee, urged the SEC to do just that. "We want some action very quickly in this area," he said.

Later in the hearing, other Senators expressed support for an independent custodian requirement. Senator Bob Corker (R-TN) called it a "no-brainer."

Is it?

During his testimony, Professor Coffee asserted that in the wake of the Madoff scandal, the Investment Adviser Association had endorsed an independent custodian requirement. "When you see the trade associations adopting reform," Coffee told the Committee, "I think it means its time is probably already overdue."

News of the IAA’s endorsement came as a surprise to us, so we nosed around a bit. Turns out, Coffee was referring to a news report on the IAA’s January 5 "Statement on Bernard Madoff and Principles for Regulatory Reform." But in that actual January 5 statement, the IAA merely recommended that the SEC "consider the circumstances, if any, under which dually-registered broker-dealers like Madoff should be permitted to self-custody client funds managed on a discretionary basis." To date, the IAA has not officially endorsed an independent custodian requirement.

Of course, most advisers already utilize an independent custodian. But as Richards pointed out, about 1,000 do not. Requiring those advisers to use an independent custodian may raise a host of practical issues. For example, what do you do about wrap programs? And what about the billions of advisory assets managed by the Goldmans, Merrills, and Morgan Stanleys of the world? (Remember all those fee-based brokerage accounts that were converted to non-discretionary advisory accounts?) Must those assets be moved to a different custodian? Would Goldman, for example, serve as custodian for Morgan Stanley? If not, how does one draw the line between a legitimate Goldman, Merrill, or Morgan Stanley, on one hand, and an illegitimate Madoff, on the other?

Amendments to Form ADV Part 1. During her testimony, Richards stated that the effectiveness of the SEC’s risk assessment process is limited by the information that is self-reported by advisers on Form ADV. In light of that, she said, the SEC staff is now looking at the adequacy of information required to be filed by registered advisers, and whether the risk assessment process would be improved with routine access to information such as "the identity of an investment adviser’s auditor, its custodian, its administrator, its performance returns, as well as additional other information."

Richards testified that on a quarterly basis, the SEC conducts a risk assessment of all registered advisers, based on their SEC filings. "Right off the bat, there is a limitation, because it is based on what they tell us," she said. "One of the things that we believe very strongly is that we should pull in additional types of data and information."

Later, in response to questioning by Senator Mark Warner (D-VA), Richards reiterated her opinion that more information needs to be collected from advisers. "I so strongly believe that the risk assessment methodology has to be improved with better access not just with respect to this data, but I believe there are other types of data points too that would help us do better risk assessment."

Indeed, the SEC staff already has begun the process of looking at what categories of additional information should be captured on Form ADV Part 1. "One of the things we were looking at" was revising Part 1 "to make it more useful" to regulators, said former SEC official David Blass, now a special counsel at Willkie Farr. The changes, he said, would include disclosure about "key gatekeepers."

What did the regulators know, and when did they know it? Professor Coffee said that he had been asked by the Senate Banking Committee to address the "quality" of regulatory supervision over Madoff. In 2006, said Coffee, the SEC knew that Madoff had investment advisory clients and therefore required him to register as an investment adviser. The next question that regulators should have asked was "Who is your custodian?" he said. "I think given the size of the investments, that some $17 billion was already, as of 2006, under his investment and management, there was a need for an immediate examination of his records and the quality of his custodial care," he said. He also noted the various red flags, such as the use of an unregistered accountant and press reports that raised questions about the firm. Questions about "What was going on at Madoff Securities?" did not occur "in secret little back rooms," he said, "but in Baron’s."

Coffee was referring to the now-infamous 2001 Baron’s article by Erin Arvedlund, "Don’t Ask, Don’t Tell." Among other things, the article recounted how Madoff was hailed at an industry conference as one of the top hedge fund managers in the country. Indeed he was: According to a 2001 MARHedge report, Madoff’s then $6 to 7 billion in assets under management "put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets."

Coffee also had words for FINRA. FINRA, he said, "did have jurisdiction over Madoff Securities." And, he added, that jurisdiction "extended to all of its activities." Moreover, he added, after 2006, the only way that Madoff could have conducted an investment advisory business was by using his own brokerage firm as the custodian. The oversight of Madoff’s custodial services was "squarely within FINRA’s jurisdiction," said Coffee. Regulators should have asked Madoff "what is going on with respect to the custodial services you are providing to one of the largest investment advisers in America?"

One of the problems is that the Baron’s article and MARHedge report notwithstanding, FINRA apparently had no inkling that Madoff was managing money, much less serving as one of the largest hedge fund managers in the country. "For two decades, FINRA examined Madoff’s broker-dealer operations at least every other year," testified Stephen Luparello, interim CEO of FINRA. "The Madoff broker-dealer consistently reported to FINRA that 90 percent of its revenues were generated by market making, and 10 percent by proprietary trading." When FINRA examined Madoff’s broker-dealer operation, he said, "FINRA found no evidence of trading for customer accounts, which is consistent with the market making model." Moreover, FINRA "did not receive any retail customer complaints that might have alerted us to the existence of the advisory accounts, and there were no complaints related to the investment advisory business."

Later in the hearing, Luparello indicated that FINRA examiners may have been misled about Madoff’s money management activity. "[T]he Madoff firm represented year in and year out in our examinations and in their Form BDs and all publicly available information that they were a wholesale market maker, one without customers, so the existence of the money management business, while perhaps known to some examiners, not to others, was seen as outside our jurisdiction."

Chairman Dodd questioned this assertion, noting that Madoff’s advisory business was not separately registered until 2006. "Up until that time, it was one entity," he said. Even now, "it’s one floor away." Dodd asked Luparello whether FINRA examiners would be deterred by "merely someone saying to you, creating this fiction, in a sense, that FINRA all of a sudden has to stop" its investigation of non-brokerage operations.

"Our ability to continue to investigate, when it is conduct that is not brokerage conduct, is somewhat more circumspect," replied Luparello.

"So if you just create this advisory operation, then you can avoid then FINRA really having any jurisdiction," Dodd asked. "Is that your argument?"

"That is the argument that has been made against us over the years," Luparello replied. "The ability to basically to take a small step and refer to your business as advisory business and therefore not require it to [be brought] into the broker-dealer has been a source of frustration for us over the years."

Later, in response to questioning from Senator Warner, Luparello put things even more plainly: "[Madoff] fundamentally misrepresented the business to us," he said. "The Form BD he filed after 2006 continued to represent no advisory business in the broker-dealer."

Warner asked whether FINRA investigators exhibited any skepticism about this claim. "There were no red flags? They accepted that at face value?" he asked.

"There were no red flags presented to us, and there was no indicia of any sort of customer activity in the books and records of the broker-dealer," replied Luparello.

Senator Corker followed up on Warner’s questions, questioning whether FINRA examiners were too accepting of Madoff’s responses. For example, he said, did FINRA examiners accept numbers at face value, or did they check accounts? Luparello assured him that they did check accounts, and repeated — yet again — his earlier statements about being misled about Madoff’s business and the fact that FINRA saw no red flags.

"Just for what its worth, as a layman sitting here, that seems hard to digest," replied Senator Corker.

At the end of the hearing, Professor Coffee suggested that Luparello’s allegations about being misled by Madoff Securities warranted additional scrutiny. "I would think the chief compliance officer of Madoff securities, who happens to be the brother of Bernie Madoff, has a lot to answer for in terms of whether he defrauded the SEC or FINRA in making false statements about the nonexistence of investment advisory clients or the failure to disclose what was the business they were actually doing."

The solution, according to Luparello, is to give FINRA greater regulatory oversight over advisers. "Madoff’s alleged fraud highlights how our current fragmented regulatory system can allow bad actors to engage in misconduct outside the view and reach of some regulators," he said. FINRA, he noted, is not authorized to examine for or enforce compliance with the Advisers Act. "Given the limitations imposed by federal law, FINRA’s authority over Madoff was and is limited to its broker-dealer operations," he said. "Unfortunately, the statutory limits of FINRA’s jurisdiction did not allow us to be an extra set of eyes looking at the totality of the Madoff business." He noted that FINRA has long expressed concerns about brokerage firms’ ability to avoid regulatory oversight by keeping certain activities outside the broker-dealer. "Investors should receive the same basic regulatory safeguards and protections no matter which investment product or service they choose," he said.

Later, Professor Coffee addressed the issue of FINRA’s jurisdictional reach over investment advisers. "It is possible that FINRA should have jurisdiction over investment advisers or alternatively that investment advisers should have to have their own self-regulatory organization," he said. "There is going to be two sides to that question. There is going to be some opposition from investment advisers, but I think that is one of the issues that should be on the table for Congress to at least recognize."

A few other items of interest from the hearing:

  • Senator Jeff Merkley (D-OR) suggested that advisers be required to undergo independent audits. "Rather than incorporating whether or not people have independent audits into a risk assessment model, why not absolutely require firms that are managing money and investments to have independent audits?" he asked. "That’s an excellent idea," replied Richards. "We would much rather be in a prevention mode than a detection and clean-up mode after the fraud has already occurred." Merkley asked Richards whether she "adamantly" supported an independent audit requirement for advisers. "As a examiner, I know the value of independent audits," Richards replied.
  • Richards testified that SEC examiners review hedge fund performance. "We have recently relied on hedge funds’ self-reported returns to a private database," she said, noting that OCIE has used those private data sources to supplement other information about hedge funds. And, she added, "we agree that performance returns can be very useful in identifying aberrations."
  • Richards said that the SEC is expanding its efforts to examine advisers and brokers in a coordinated approach, in order to reduce the opportunities for firms to shift activities to an area where they are not subject to regulatory oversight. She also testified that the SEC staff is studying examination frequencies for investment advisers, the existence of unregistered funds and advisers, the different regulatory structures surrounding brokers and advisers, the existence of unregulated products, and ways to strengthen custody and audit requirements for regulated firms.
  • Dodd asked SEC and FINRA officials to report every three months to the Senate Banking Committee on how they are improving the effectiveness of examinations and the handling of credible tips.