(The article featured below is a selection from Federal Securities Law Reporter, which is available to subscribers of that publication.)

New Investor Asset Custody Rules Proposed

The SEC approved the issuance of proposed new rules to strengthen the investment adviser custody requirements. In remarks at the open meeting, Chairman Mary Schapiro said the action was in response to major investment scams, including the alleged Bernard Madoff Ponzi scheme. The proposal would add a requirement that all registered advisers with custody of client assets must undergo a "surprise" examination by an independent public accountant. Investment advisers whose client assets are not held by a firm independent of the adviser would be required to obtain a written report from an accountant registered with the Public Company Accounting Oversight Board about the adviser's controls.

Ms. Schapiro said that approximately 9,600 registered investment advisers have custody of client assets in one form or another. They either control the assets directly or through an affiliate. Given investors' concerns about the safety of these assets, the chairman said the SEC's proposal would substantially increase the controls that apply to investment advisers that maintain custody of client assets.

The proposed surprise examination conducted by an independent public accountant would verify that client assets exist. The accountants would be required to notify the SEC within a day if they discover any material discrepancies. The current rules do not require a surprise examination if the custodian sends statements directly to the clients.

If the assets are held by an affiliate that is not independent of the adviser, the proposal will require that a PCAOB-registered and inspected accountant prepare a report on the effectiveness of the internal controls. These reports are known as Type II SAS-70 reports. The review would have to meet PCAOB standards. Current rules do not require third party reviews. Chairman Schapiro said that the PCAOB registration and inspection requirement would provide an additional level of quality control over the accountants that perform the compliance review.

Associate Director Robert Plaze noted that when the staff has found fraud by investment advisers, there has been no accountant in sight. The accountant has either been fired or was never engaged. The proposal will require advisers to report on Form ADV Part I the name of the accountant who will conduct the surprise audit and whether an accountant has been fired or otherwise let go. If there is a disagreement between the adviser and the accountant, it must be reported to the SEC. The accountant has the flexibility to look beyond the custodian to ensure that the assets exist, he added.

Commissioner Troy Paredes voted in support of the proposal but outlined a number of concerns with the potential costs. He noted that the Commission considered a similar proposal in 2003 but chose not to act, partly based on a cost/benefit assessment. Commissioner Paredes questioned whether the proposal should cover investment advisers with an independent qualified custodian since nonaffiliated custodians already serve as a safeguard of client assets. He also questioned whether the rules should cover advisers that have custody only because they withdraw fees from client accounts. The commissioner raised concerns about the potential costs to smaller entities and the potential moral hazard that may arise with the false sense of security from the proposal that may lead to a lack of due diligence on behalf of investors.

The comment period will remain open for 60 days.