Surprise SEC examinations of investment advisors with custodial control over their investors' assets have identified compliance issues in around 100 advisors since early 2010, according to a report from the Government Accountability Office.
The report noted that SEC staff told the GAO that "the surprise examination requirement, like any regulation, cannot prevent fraud 100 percent of the time but that it helps deter such misconduct."
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Even under increased scrutiny imposed by the SEC, opportunities to defraud still exist, the report said.
Most financial advisors don't have direct control over their clients' assets; those assets are usually managed by banks or broker/dealers. Some advisors, however, have the authority to directly deduct fees for their services or write checks on clients' accounts, which grants them a level of control many of them don't even realize they have. These advisors, unless they qualify for an exception, are required to hire an independent public accountant to conduct an annual surprise examination to verify custody of their clients' assets.
Part of the problem, the report said, is that the accountants advisors hire to conduct the exams must rely on advisors themselves to provide them with a complete list of the client assets in their custody in order to verify them.
The report found that out of 4,446 advisors who had custody of client assets, 1,321 were subject to surprise exams. There were 2,956 advisors who didn't have to submit to exams; 169 were exempted because they were deemed to have custody of certain assets solely because of their use of related but "operationally independent" custodians.
The surprise exams cost advisors interviewed by the GAO between $3,500 and $31,000, depending on the number of accounts they manage, according to the report.
The SEC expanded and strengthened its custody rule in 2009, including the use of surprise inspections, in the wake of the Bernie Madoff scandal. The Dodd-Frank financial reform law mandates that the GAO monitor and report on the costs and impact of the SEC's custody rule.
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