Investment Advisers: Requirements and Costs Associated with the Custody Rule
Published: 2013-07-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Investment advisers provide a wide range of services and collectively manage around $54 trillion in assets for around 24 million clients. Unlike banks and broker-dealers, investment advisers typically do not maintain physical custody of client assets. However, under federal securities regulations, advisers may be deemed to have custody because of their authority to access client assets, for example, by deducting advisory fees from a client account. High-profile fraud cases in recent years highlighted the risks faced by investors when an adviser has custody of their assets. In response, SEC amended its custody rule in 2009 to require a broader range of advisers to undergo annual surprise examinations by independent accountants. At the same time, SEC provided relief from this requirement to certain advisers, including those deemed to have custody solely because of their use of related but "operationally independent" custodians. The Dodd-Frank Wall Street Reform and Consumer Protection Act mandates GAO to study the costs associated with the custody rule. This report describes (1) the requirements of and costs associated with the custody rule and (2) SEC's rationale for not requiring advisers using related but operationally independent custodians to undergo surprise examinations.
To address the objectives, GAO reviewed federal securities laws and related rules, analyzed data on advisers, and met with SEC, advisers, accounting firms, and industry and other associations.
section_title: What GAO Found
paragraphs: Designed to safeguard client assets, the Securities and Exchange Commission's(SEC) rule governing advisers' custody of client assets (custody rule) imposes various requirements and, in turn, costs on investment advisers. To protect investors, the rule requires advisers that have custody to (1) use qualified custodians (e.g., banks or broker-dealers) to hold client assets and (2) have a reasonable basis for believing that the custodian sends account statements directly to clients.
The rule also requires advisers with custody, unless they qualify for an exception, to hire an independent public accountant to conduct annually a surprise examination to verify custody of client assets. According to accountants that GAO interviewed, examination cost depends on an adviser's number of clients under custody and other factors. These factors vary widely across advisers that currently report undergoing surprise examinations: for example, their reported number of clients under custody ranged from 1 client to over 1 million clients as of April 2013. Thus, the cost of the examinations varies widely across the advisers. The rule also requires advisers maintaining client assets or using a qualified custodian that is a related person to obtain an internal control report to assess the suitability and effectiveness of controls in place. The cost of these reports varies across custodians based on their size and services.
SEC provided an exception from the surprise examination requirement to, among others, advisers deemed to have custody solely because of their use of related but "operationally independent" custodians. According to SEC, an adviser and custodian under common ownership but having operationally independent management pose relatively lower client custodial risks, because the misuse of client assets would tend to require collusion between the firms' employees. To be considered operationally independent, an adviser and its related custodian must not be under common supervision, not share premises, and meet other conditions. About 2 percent of the SEC-registered advisers qualify for this exception for at least some of their clients. If the exception were eliminated, the cost of the surprise examination would vary across the advisers because the factors that affect examination cost vary widely across the advisers.

section_title: Letter
paragraphs: Investment advisers provide a wide range of investment advisory services  and collectively manage around $54 trillion in assets for about 24 million  clients. Unlike banks and broker-dealers, investment advisers typically do  not maintain physical custody of client assets—that is, client funds and  securities. However, under federal securities regulations, advisers may be  deemed to have custody because of their authority to access client  assets, for example, by deducting advisory fees from a client account.  The collapse of Bernard L. Madoff Investment Securities, LLC—an  investment adviser and broker-dealer—in December 2008 resulted in  thousands of investors losing over $50 billion and highlighted the risks  investors face when an adviser has custody of client funds and securities.
See 75 Fed. Reg. 1456, 1457, 1475 (2010). acts, practices, or courses of business. At that time, the rule generally  required, among other things, that advisers with custody hire an  independent public accountant to conduct an annual surprise examination  to verify custody of client assets. In 2003, SEC amended the rule to  require advisers to adopt new controls to protect client assets and relieve  certain advisers from the surprise examination requirement. In response  to the Madoff and other recent frauds, SEC amended the rule again in  2009 to improve the safekeeping of client assets—in part by expanding  the surprise examination requirement’s reach. As noted by SEC in its  2009 final rule adopting release, surprise examinations provide “another  set of eyes” on client assets and thus additional protection against their  misappropriation. Under the amended rule, SEC continued to provide an  exception from the surprise examination requirement to certain advisers,  including advisers that have custody solely because of their use of related  but “operationally independent” custodians to hold client assets.
Pub. L. No. 111-203, § 412, 124 Stat.1376, 1577 (2010). the requirements of and costs associated with the SEC custody rule,  including any related record-keeping requirements, for registered  investment advisers; and
SEC’s rationale for not requiring advisers using related but  operationally independent custodians to undergo surprise  examinations, and the number and characteristics of such advisers.
To address these objectives, we reviewed and analyzed the Advisers Act  and related regulations; proposed and final amendments made to SEC’s  custody rule, including comment letters; and relevant GAO, SEC,  industry, and academic studies on investment advisers. We also analyzed  publicly available Form ADV data filed by investment advisers to  determine, among other things, the number of SEC-registered investment  advisers that reported complying with certain custody rule requirements,  including the surprise examination requirement, and assess the  characteristics of certain investment advisers. We interviewed SEC staff  about the controls and procedures used to ensure the reliability of the  data and found the data to be sufficiently reliable for the purposes of our  report.
To obtain data on costs of complying with the SEC custody rule,  particularly its surprise examination and internal control report  requirements, we selected 12 investment advisers based on the number  of their client accounts and amount of assets under custody. We  interviewed eight of the advisers and four accounting firms that had  conducted surprise examinations for the 12 selected advisers to obtain  data on surprise examination costs and, if applicable, internal control  reports. To obtain information about the requirements, costs, and other  issues associated with the SEC custody rule, we interviewed, among  others, federal and state regulators and representatives from various  industry and other associations. (See app. I for more information about  our scope and methodology.)
We conducted this performance audit from September 2012 through July  2013 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Investment advisers provide a wide range of investment advisory services  and help individuals and institutions make financial decisions. From  individuals and families seeking to plan for retirement or save for college  to large institutions managing billions of dollars, clients seek the services  of investment advisers to help them evaluate their investment needs, plan  for their future, and develop and implement investment strategies.  Advisers can include money managers, investment consultants, and  financial planners. They commonly manage the investment portfolios of  individuals, businesses, and pooled investment vehicles, such as mutual  funds, pension funds, and hedge and other private funds. Many  investment advisers also engage in other businesses, such as insurance  broker or broker-dealer services. Many investment advisers charge  clients fees for investment advisory services based on the percentage of  assets under management, but others may charge hourly or fixed rates  and, in certain circumstances, performance fees.
15 U.S.C. § 80b-2(a)(11).
Advisers Act’s registration requirement.broad fiduciary duty on advisers to act in the best interest of their clients.
The Advisers Act imposes a  Most small- and mid-sized advisers are regulated by the states and  prohibited from registering with SEC.an exemption from registration must register with SEC. To register,  applicants file a Form ADV with SEC. Once registered, an adviser must  update the form at least annually. SEC-registered advisers are subject to  five types of requirements: (1) fiduciary duties to clients; (2) substantive  prohibitions and requirements, including that advisers with custody of  client assets take steps designed to safeguard those client assets; (3)  contractual requirements; (4) record-keeping requirements; and (5)  oversight by SEC.
Large advisers who do not meet  SEC oversees registered investment advisers primarily through its Office  of Compliance Inspections and Examinations, Division of Investment  Management, and Division of Enforcement. Specifically, the Office of  Compliance Inspections and Examinations examines investment advisers  to evaluate their compliance with federal securities laws, determines  whether these firms are fulfilling their fiduciary duty to clients and  operating in accordance with disclosures made to investors and  contractual obligations, and assesses the effectiveness of their  compliance-control systems. The Division of Investment Management  administers the securities laws affecting investment advisers and  engages in rule making for consideration by SEC and other policy  initiatives that are intended, among other things, to strengthen SEC’s  oversight of investment advisers. The Division of Enforcement  investigates and prosecutes certain violations of securities laws and  regulations.
Nearly 10,000 advisers were registered with SEC as of April 1, 2013.Collectively, these advisers managed nearly $54 trillion in assets for  about 24 million clients. The majority of these SEC-registered advisers  each managed less than $1 billion in assets, and a majority had 100 or  fewer clients. Specifically, as shown in figure 1, about 71 percent of the  registered advisers (around 7,133 advisers) managed less than $1 billion  in assets. Furthermore, the largest 94 registered advisers (about 1  percent of all SEC-registered advisers) managed about 50 percent of the  total regulatory assets under management.
In addition, as shown in figure 2, about 6,000 registered advisers (nearly  60 percent of all registered advisers) reported having 100 or fewer clients,  while approximately 1,200 advisers (around 12 percent of all registered  advisers) reported having more than 500 clients.
section_title: Custody Rule Requirements and Compliance Costs Vary across Advisers
paragraphs: An adviser  indirectly, client funds or securities or has any authority to obtain  possession of them, in connection with advisory services provided by the  adviser to the client. Custody includes: possession of client funds or securities; any capacity that gives the adviser legal ownership or access to client  assets, for example, as a general partner of a limited partnership,  managing member of a limited liability company, or a comparable  position for another pooled investment vehicle (e.g., hedge fund); or any arrangement, including a general power of attorney, under which  the adviser is authorized or permitted to withdraw client funds or  securities maintained with a custodian upon its instruction to the  custodian.
subsections: section_title: Custody Rule Requirements Are Intended to Safeguard Client Assets
paragraphs: SEC’s custody rule regulates the custody practices of investment  advisers and contains a number of investor protections. The rule requires  advisers that have custody to maintain client assets with a “qualified  custodian,” which includes banks and savings associations, registered  broker-dealers, registered futures commission merchants, and certain  foreign financial institutions. This requirement, along with other parts of  the rule, helps prevent client assets from being lost or stolen.  Furthermore, qualified custodians are subject to regulation and oversight  by federal financial regulators and self-regulatory organizations. Some  registered advisers also engage in other businesses, such as broker- dealers that provide custodial services to themselves or related advisers.
The rule requires advisers that have custody of client assets to have a  reasonable basis, after due inquiry, for believing that the custodian sends  periodic statements directly to the clients. An adviser can satisfy the  due-inquiry requirement in a number of ways, such as by receiving a copy  of the account statements sent to the clients or written confirmation from  the custodian that account statements were sent to the adviser’s clients.  This requirement serves to help assure the integrity of account  statements and permit clients to identify any erroneous or unauthorized  transactions or withdrawals by an adviser. If an adviser also elects to  send its own clients account statements, it must include a note urging its  clients to compare the custodian’s and adviser’s account statements.
The SEC custody rule requires advisers with custody of client assets to  hire an independent public accountant to conduct an annual surprise  examination, unless the advisers qualify for an exception.  A surprise  examination is intended to help deter and detect fraudulent activity by  having an independent accountant verify that client assets—of which an  adviser has custody—are held by a qualified custodian in an appropriate  account and in the correct amount. The accountant determines the time  of the examination without prior notice to the adviser, and the accountant  is to vary the timing of the examination from year to year. SEC initially  required all advisers to undergo surprise examinations when it adopted  the custody rule in 1962. Over the following decades of administering  the custody rule, SEC staff provided no-action relief from the surprise  examination requirement where other substitute client safeguards were  implemented. In 2003, SEC amended the custody rule by generally  requiring an adviser to maintain client assets with qualified custodians  and relieving the adviser from the examination requirement if its qualified  custodian sent account statements directly to the adviser’s clients. In its  proposed rule at that time, SEC noted that the examination was  performed only annually, and many months could pass before the  accountant had an opportunity to detect a fraud. In its 2009 proposed  amendments, SEC revisited the 2003 rule making in light of its significant  enforcement actions alleging misappropriation of client assets. In  expanding the surprise examination requirement, SEC noted that an  independent public accountant may identify misuse that clients have not,  which would result in the earlier detection of fraudulent activities and  reduce resulting client losses.
While SEC expanded the reach of the surprise examination requirement  in its final 2009 rule amendments, it provided several exceptions to the  requirement. As shown in figure 3, advisers meeting the following  conditions may not be required to undergo a surprise examination: an adviser that is deemed to have custody of client assets solely  because of its authority to deduct fees from client accounts; an adviser that is deemed to have custody because a related person  has custody, and the adviser is “operationally independent” of the  related person serving as the custodian; or an adviser to a pooled investment vehicle (e.g., hedge fund) that is  subject to an annual financial statement audit by an independent  public accountant registered with and subject to regular inspection by  the Public Company Accounting Oversight Board (PCAOB) and  distributes the audited financial statements prepared in accordance  with generally accepted accounting principles to its clients is deemed  to have satisfied the surprise examination requirement.
Advisers that maintain client assets as the qualified custodian or use a  related person qualified custodian rather than maintaining client assets  with an independent qualified custodian may present higher risk to clients.  In recognition of such risk, SEC also imposed in its 2009 rule  amendments a new internal control reporting requirement on advisers  that maintain client assets or use related person qualified custodians (see  fig. 3 above). The internal control report must include an opinion of an  independent public accountant as to whether suitable controls are in  place and operating effectively to meet control objectives relating to  custodial services. This includes the safeguarding of assets held by the  adviser or related person. An adviser that directly maintains client assets  as a qualified custodian or maintains client assets with a related person  qualified custodian must obtain or receive from its related person an  internal control report annually from an accountant that is registered with  and subject to regular inspection by PCAOB. Advisers qualifying for a  surprise examination exception because of their use of a related person  but operationally independent custodian still must obtain an internal  control report from their related person.
In conjunction with the amendments to the custody rule, SEC also  amended its record-keeping rule. The revised rule requires advisers to  maintain a copy of any internal control report obtained or received  pursuant to the SEC custody rule. The rule also requires advisers, if  applicable, to maintain a memorandum describing the basis upon which  they determined that the presumption that any related person is not  operationally independent under the custody rule has been overcome.  According to SEC, requiring an adviser to retain a copy of these items  provides SEC examiners with important information about the safeguards  in place and assists SEC examiners in assessing custody-related risks.
section_title: Compliance Requirements and Costs Vary
paragraphs: Around 4,400 advisers, about 45 percent of all SEC-registered advisers,  reported having custody (for reasons other than their authority to deduct   In addition,  fees) of over $14 trillion in client assets as of April 1, 2013.around 500 advisers, about 11 percent of the 4,400 advisers with  custody, reported serving as the qualified custodian or having a related  person qualified custodian of client assets. As discussed, the SEC  custody rule imposes certain minimum requirements generally on all  advisers with custody, but not all of the rule’s requirements apply to all  advisers. Instead, the rule generally imposes more stringent requirements  on advisers whose custodial arrangements, in SEC’s view, pose greater  risk of misappropriation or other misuse of client assets.
According to representatives from industry associations and advisers that  we interviewed, advisers can incur an array of direct and indirect costs to  comply with the SEC custody rule. Direct costs, such as accounting and  legal fees paid by advisers, tend to be more easily measured than indirect  costs, such as staff hours spent by an adviser to comply with the rule.  The representatives told us that compliance costs include the following:  Initial costs: After the SEC custody rule was amended in 2009,  advisers initially incurred indirect costs (largely management and staff  hours) and, in some cases, direct costs (largely consulting or legal  fees) to interpret the amendments and comply with the rule’s new or  amended requirements. For example, one adviser told us that his firm  hired a law firm to help it interpret the amended rule, hired a part-time  person for 6 months to review and determine over which accounts the  adviser had custody, and utilized staff to reprogram the firm’s  information system to code accounts under custody. Another adviser  told us that his firm had the necessary in-house expertise to interpret  the amended rule but nevertheless expended considerable internal  resources for training staff about the surprise examination  requirements and searching for and hiring an accountant to conduct  the examinations.
Recurring costs: On an ongoing basis, advisers incur indirect and, in  some cases, direct costs to comply with the custody rule. Advisers  expend internal staff hours to maintain records and prepare required  statements and disclosures, including Form ADV (the form that  advisers use to register with SEC and must update annually).  Advisers subject to the surprise examination or internal control report  requirement expend staff hours to prepare for and facilitate such  reviews. For example, an official from an adviser told us that the firm  expends considerable staff hours each year educating the accountant  about the firm’s operations, generating reports for and providing other  support to the accountant, and answering questions from clients  related to the examination. In addition, these advisers may incur the  direct cost of the examination or audit, and the amount of these fees  varies from adviser to adviser (as discussed later in the report).
Although advisers to pooled investment vehicles often undergo an  annual financial statement audit in lieu of a surprise examination, they  incur the indirect and direct costs associated with the audit.
According to SEC staff and representatives from three industry  associations that we spoke with, surprise examinations and internal  control reporting, if applicable, tended to be two of the more costly  requirements associated with SEC’s custody rule. In contrast, record- keeping costs were not significant, according to officials from three  associations, two securities law attorneys, and seven of the advisers with  whom we spoke.
According to representatives we interviewed from four accounting firms,  their surprise examination fee is based on the amount of hours required  to conduct the examinations, which is a function of a number of factors.  One of the most important factors is the number of client accounts under  custody, which influences the number of accounts that accountants will  need to review to verify custody. Other factors affecting examination cost  include the amount of client assets under custody, types of securities  under custody, and number and location of the custodians. Over 1,300  advisers with custody of client assets, about 30 percent of the 4,400  advisers with custody, reported being subject to the surprise examination  requirement as of April 1, 2013. Importantly, these advisers vary widely in  terms of the number of their clients under custody—reported by advisers  as ranging from 1 client to over 1 million clients—and other factors that  affect the cost of surprise examinations. Consequently, the cost of  surprise examinations varies widely across the advisers.
Although no comprehensive data exist on surprise examination costs,  several industry associations and SEC have provided estimates. In  response to SEC’s 2009 proposed amendments to the custody rule,  industry associations provided SEC with cost estimates. For example, the  Investment Advisers Association, representing SEC-registered advisers,  estimated that surprise examinations would likely cost each of its  members between $20,000 and $300,000. The Securities Industry and  Financial Markets Association, representing major asset management  firms and custodians, estimated that surprise examination costs would  range from $8,000 to $275,000 for each of its members. However, these  estimates were based on the then-current SEC guidance to accountants  that required verification of 100 percent of client assets under custody. In  conjunction with its 2009 final rule amendment, SEC issued a companion  release that revised the guidance to allow accountants to verify a sample  of client assets. In its 2009 final amendments to the custody rule, SEC  estimated the cost of surprise examinations for large, medium, and small  advisers in consideration of revisions to its guidance that allowed  accountants to verify a sample of client assets. In particular, SEC  estimated that the average cost of a surprise examination for large,  medium, and small advisers would be $125,000, $20,000, and $10,000,  respectively.
To help determine the range of potential costs of surprise examinations  for selected subgroups of advisers, we obtained data on the examination  fees for 12 advisers.  As shown in figure 4, the fees that the 12 advisers  paid to their independent public accountants for recent surprise  examinations ranged from $3,500 to $31,000. Figure 4 also shows that  fees varied among advisers we selected within each of the subgroups.  For example, fees in subgroup 2 ranged from $3,500 to $16,000 for the  three advisers we selected.
Fewer than 500 advisers, about 11 percent of advisers with custody,  reported obtaining internal control reports as of April 1, 2013. Similar to  surprise examination costs, the cost of internal control reports varies  based on a number of factors, such as the size of and services offered by  the qualified custodian. In its final 2009 rule, SEC estimated that an  internal control report relating to custody would cost, on average,  $250,000. According to officials from four accounting firms we spoke  with, internal control reporting costs for their clients may range from  $25,000 to $500,000. Unlike with surprise examinations and associated  costs, some advisers and their related person qualified custodians may  obtain internal control reports for reasons other than the custody rule. For  example, representatives from two industry associations told us that  institutional investors commonly require their custodians that are related  persons to their advisers to obtain internal control reports.
section_title: SEC Views Advisers Using Related but Operationally Independent Custodians as Posing Relatively Low Risk
paragraphs: SEC provided certain investment advisers with an exception from the  surprise examination requirement because their custodial practices pose  relatively lower risk or they adopted other controls to protect client assets,  such as annual financial statement audits. The broad range of industry,  regulatory, and other parties that we interviewed generally supported or  did not have a view on the surprise examination exception provided to  advisers using related but operationally independent custodians to hold  client assets.
subsections: section_title: SEC Excepted Advisers from Surprise Examination Requirement for Several Reasons
paragraphs: Although SEC’s 2009 proposed amendments to the custody rule would  have required all registered advisers with custody of client assets to  undergo a surprise examination, SEC provided exceptions from the  requirement to certain advisers in the final 2009 rule amendments. In the  2009 amendments, SEC expressed that the surprise examination  requirement should help deter fraud because advisers will know their  client assets are subject to verification at any time and, thus, may be less  likely to engage in misconduct. SEC noted that if fraud does occur, the  examination will increase the likelihood that the fraud will be detected  earlier.
As discussed earlier, advisers deemed to have custody solely because of  their authority to deduct fees from client accounts are excluded from the  surprise examination requirement. In SEC’s view, the magnitude of the  risks of client losses from overcharging advisory fees did not warrant the  costs of obtaining a surprise examination. Also excluded from the  requirement are advisers to a pooled investment vehicle that undergo  annual audits of their financial statements by an independent public  accountant and distribute the audited statements to investors. According  to SEC, procedures performed by accountants during the course of a  financial statement audit provide meaningful protections to investors, and  the surprise examination would not significantly add to these  protections.
75 Fed. Reg. at 1464. advisory personnel and personnel of the related person who have  access to advisory client assets are not under common supervision;  and advisory personnel do not hold any position with the related person or  share premises with the related person.
Although an adviser that meets these conditions would not be required to  undergo a surprise examination, the adviser still would be required to  comply with the rule’s other applicable provisions, including obtaining an  internal control report from its related person. SEC emphasized that an  adviser that has custody due to reasons in addition to a related person  having custody cannot rely on the exception because it is only applicable  if an adviser has custody solely because its related person has custody.  For example, an adviser that has custody because he or she serves as a  trustee with respect to client assets held in an account at a broker-dealer  that is a related person could not rely on the exception from the surprise  examination on the grounds that the broker-dealer was operationally  independent, because the adviser has custody for reasons other than  through its operationally independent related person.
section_title: A Limited Number of Advisers Do Not Undergo Surprise Examinations Because They Use Related but Operationally Independent Custodians
paragraphs: As of April 1, 2013, 169 registered advisers reported having custody of  client assets and using related but operationally independent custodians and not undergoing an annual surprise examination for certain clients.These advisers account for around 2 percent of all SEC-registered  advisers and about 42 percent of the approximately 400 SEC-registered  advisers that have a related person holding client assets. These advisers  collectively have over $6 trillion in regulatory assets under management  and custody of over $1 trillion of client assets. The structure of large  institutions with functionally independent subsidiaries tends to lend itself  to meet the operationally independent conditions. More specifically, we  identified some advisers using related but operationally independent  custodians that are part of large financial institutions with numerous  subsidiaries, such as Deutsche Bank, JPMorgan Chase, Morgan Stanley,  and Wells Fargo. According to SEC staff, this outcome is to be expected  given that the adviser and custodian staff cannot be considered  operationally independent while under common supervision and sharing  the same premises.
If advisers currently qualifying for an exception from the surprise  examination requirement were required to undergo such examinations,  the costs of the examinations would likely vary considerably across the  advisers. Like advisers currently subject to the surprise examination  requirement, advisers excepted from the requirement vary considerably in  terms of the factors that affect the cost of the examinations. For example,  the number of clients these advisers had under custody ranged from 1  client to over 500,000 clients, as of April 1, 2013. Similarly, the amount of  client assets under their custody ranged from $680,000 to $320 billion.
section_title: Views on the Surprise Examination’s Exception and Effectiveness
paragraphs: The broad range of industry, accounting firms, and other parties we  interviewed largely told us that they either support or do not have a view  on the surprise examination exception. However, several of these  representatives said that the exception’s operationally independent   None of the investment  conditions were too stringent or difficult to meet.advisers we interviewed use a related custodian to hold client assets, and  most did not have a view on the exception or SEC’s rationale. The North  American Securities Administrators Association (NASAA) staff told us that  when a custodian is a related person of the adviser, ensuring that the  adviser meets and complies with the operationally independent conditions  would require the firm to conduct a thorough analysis of its operations  and any changes that may affect the custodian’s operational  independence. The staff further noted that NASAA’s custody model rule  for use by state securities regulators, unlike the SEC custody rule, does  not include an exception from the surprise examination requirement  based on the concept of operational independence between an  investment adviser and a custodian that is a related person.advocacy representative told us that he generally opposes allowing  advisers to use related custodians, but if that were allowed, he said that,  in his opinion, the surprise examination exception would be appropriate  for only large, complex entities subject to existing regulation, such as  banks and broker-dealers.
Many of the industry, regulatory, and other parties we interviewed agreed  with SEC’s view that surprise examinations can help to deter fraud.  However, some told us that one of the examination’s weaknesses is that  accountants must rely on advisers to provide them with a complete list of  the client assets under custody to verify. According to some of these  representatives, an adviser defrauding a client could omit that client’s  account from the list provided to the accountant to avoid detection.  Officials from an accounting firm told us that no infallible procedure exists  to test the completeness of the client list, given that the list must come  from the adviser. According to SEC staff, an adviser with custody and  intent on defrauding its clients also may not register with SEC or, if it  does, may not report that it has custody of client assets or hire an  accountant to conduct a surprise examination. SEC staff also noted that  the surprise examination requirement, like any regulation, cannot prevent  fraud 100 percent of the time but that it helps deter such misconduct.
SEC data indicate that surprise examinations have identified compliance  issues and helped target higher-risk advisers for examination. SEC staff  told us that since the 2009 custody rule amendments became effective in  March 2010, auditors conducting surprise examinations have found  around 100 advisers with one or more instances of material  noncompliance with the rule, such as failing to maintain client securities at  a qualified custodian. According to SEC staff, the results of surprise  examinations serve as an early warning of potential risks and are used by  staff to help assess the risk level of advisers and, in turn, select advisers  for SEC examination. For example, in March 2013, SEC’s Office of  Compliance Inspections and Examinations issued a “Risk Alert” that  noted that about 33 percent (over 140 examinations) of recent SEC  examinations found custody-related deficiencies.included failures to comply with the rule’s surprise examination  requirement and qualified custodian requirements and resulted in actions  ranging from immediate remediation to enforcement referrals and  subsequent litigation.
section_title: Agency Comments
paragraphs: We requested comments from SEC, but none were provided. SEC  provided technical comments, which we incorporated, as appropriate.
We are sending copies of this report to SEC, interested congressional  committees and members, and others. The report also is available at no  charge on the GAO website at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix II.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report describes (1) the requirements of and costs associated with  the Securities and Exchange Commission (SEC) custody rule, including  any related record-keeping requirements, for registered investment  advisers, and (2) SEC’s rationale for not requiring advisers using related  but operationally independent custodians to undergo surprise  examinations, and the number and characteristics of such advisers.
To address both objectives, we analyzed SEC’s record-keeping and  custody rules under the Investment Advisers Act of 1940 to document  compliance requirements (e.g., surprise examinations and internal control  reports) for SEC-registered investment advisers. Furthermore, we  reviewed proposed and final SEC amendments to the custody rule,  comment letters, and other information, such as GAO and other studies,  to analyze how and why the custody rule requirements have changed,  particularly the surprise examination requirement and exceptions, and  obtain information on compliance costs. We analyzed publicly available  data in the Investment Adviser Registration Depository (IARD) to identify  the number of SEC-registered investment advisers and information  advisers reported about their compliance with the SEC custody rule’s  requirements. IARD data are submitted by advisers in Form ADV, which  is used by advisers to register with SEC and must be updated annually by  advisers. We assessed the reliability of Form ADV data by interviewing  SEC staff and testing the data for errors, and we determined the data  were sufficiently reliable for our purposes. Specifically, we interviewed  SEC staff about the IARD database and Form ADV to understand how  the data are collected, what types of edit checks are incorporated into the  system, and the staff’s overall views of the system’s data reliability with  respect to our purposes. We also performed electronic testing to identify  potential errors, and we discussed analysis methodology considerations,  such as excluding particular records, with SEC staff for any  inconsistencies that we identified. For the purposes of our final analysis,  we excluded records for advisers that reported zero as the regulatory  assets under management or total clients and any record with the latest  Form ADV filing date older than January 2012.
To obtain data on the costs of complying with the SEC custody rule,  particularly its surprise examination and internal control report  requirements, and other information, we interviewed a limited number of  investment advisers and accounting firms. Based on Form ADV data as  of December 3, 2012, we identified approximately 1,300 advisers that  reported undergoing surprise examinations. To systematically target  advisers and firms, we first divided the total group of advisers that  reported undergoing surprise examinations into four subgroups based on  whether the amount of their client assets under custody were above or  below the group’s median value of approximately $101 million and  whether their number of clients under custody were above or below the  median of 19 clients, as shown in figure 5. Thus, at one end of the  spectrum, subgroup 1 includes advisers whose number of clients and  amount of client assets under custody were both below the group’s  median values. At the other end of the spectrum, subgroup 3 includes  advisers whose number of clients and amount of client assets were both  above the group’s median values. Within each subgroup, we then  selected advisers whose client assets were around the subgroup’s  median value. For the 12 selected advisers, we interviewed eight of the  advisers and interviewed four accountants who conducted the surprise  examinations for the other four advisers.
To obtain information on the cost of complying with the custody rule and  other information, we also interviewed regulators, including SEC staff,  officials from the North American Securities Administrators Association,  and a representative from a state securities authority, and representatives  from investment adviser, accountant, investor advocacy, and other  associations, including the American Institute of Certified Public  Accountants, American Bankers Association, Financial Services Institute,  Fund Democracy, Investment Advisers Association, Managed Futures  Association, Private Equity Growth and Capital Council, and Securities  Industry and Financial Markets Association. In addition, we interviewed  two securities law attorneys.
We conducted this performance audit from September 2012 through July  2013 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Richard Tsuhara, Assistant  Director; Carl Barden; William Chatlos; F. Chase Cook; Kristen Kociolek;  Risto Laboski; Grant Mallie; Patricia Moye; Jennifer Schwartz; Jena  Sinkfield; and Verginie Tarpinian made major contributions to this report.