The U.S. Government Accountability Office (“GAO”) contacted FSI in October requesting information in connection with their efforts under a Dodd-Frank mandate requiring GAO to conduct a study of the Securities and Exchange Commission (“SEC”) rule governing the custody of client assets by registered investment advisers under the Investment Advisers Act of 1940. This study seeks to evaluate the compliance costs imposed on investment advisory firms in connection with the custody rule and the SEC’s new surprise examination requirement. On November 15, 2012, David Bellaire, Justin Nazari, and Christopher Hayes of FSI conducted a conference call with GAO to discuss the results of our outreach to members on this topic.
During the discussion, FSI pointed out that all of the member firms the FSI staff discussed the issues with are dual-registered as both broker-dealers and investment advisers, and are therefore subject to heightened scrutiny and regular exams from FINRA regarding their custody procedures. FSI communicated with ten member firms concerning the effectiveness of the annual surprise examinations. Every firm FSI discussed these issues with indicated that the surprise exam has failed to detect the misuse of client assets. However, FSI member firms have been burdened with additional compliance costs as a result of the SEC’s rule change, with annual surprise examination costs ranging from $40,000 for smaller firms to $350,000 for larger firms with multiple subsidiaries. The GAO indicated that these findings were consistent with what they had learned from other financial services organizations and firms they had also had discussions with.
GAO also inquired as to whether our members had found the limited exemption to the custody rule for “operationally independent custodians” to be helpful, and wanted to know if any of our members had taken advantage of it. FSI indicated that our members either did not know of the exemption or found that the exemption’s language is too strict for firms to qualify. None of the members FSI contacted have utilized the “operationally independent custodian” exemption. This was also consistent with what GAO had heard from other financial firms and organizations.
GAO made some promising statements during the course of the discussion including that there was a general consensus among stakeholders that the investor protection benefits were much too low to justify the high compliance costs imposed under the custody rule, particularly for dual registrants. The GAO report will likely be completed in July of 2013. GAO is currently in the design phase where it is reaching out to stakeholders and will move shortly to the recommendation phase. However, the GAO indicated that they may not issue recommendations and instead merely provide a descriptive report of the issues presented by the custody rule.