It’s been awhile. Mostly I’ve been on the road, both attending industry conferences and visiting out-of-town clients. Where do I begin…
A couple days ago we finally learned Bernie Madoff’s fate. I think 3 lifetimes is about right for what he did. And though I in no way wish to devalue the horror of what he did to clients directly, the impact of his scheme will almost surely reach far beyond the people with whom he had direct contact.
A case in point: The SEC – the agency that could have and should have uncovered Madoff’s fraud many years ago as a consequence of powers and processes that they already possessed at the time – is now understandably feeling the heat. As a result, the folks at the SEC have proposed a new rule for the Registered Investment Advisor community, viz that investment advisors all be subjected to a an annual “surprise” audit of their clients’ assets – at their own expense of course.
If this sounds like a good idea to you, please keep in mind that this is Washington we’re talking about here. It is supposed to sound good. But in fact it will do nothing to uncover Madoff-type fraud while it will harm all existing clients by increasing the cost of doing business, costs that must and will in turn be recouped from those clients themselves. Let me explain.
The problem with Bernie’s operation was not simply that he operated as an RIA. The problem was that he also simultaneously played two additional roles: he ran a broker-dealer operation and he ran a hedge-fund type investment scheme. All three operations were managed under the same roof (and no, I do not believe that it is remotely possible that Bernie pulled all this off by himself and without the knowledge and cooperation of others in the operation). It is in the interconnectedness of the three operations that lay the risk. Bernie’s RIA business could get away with lying to his clients specifically because – and only because – his broker-dealer and his investment fund mirrored the same lie.
99.99% of RIAs, on the other hand – such as yours truly – have no such control over either the broker-dealer they work with or over the funds they invest in on behalf of clients. Yet without such control they don’t stand a snowball’s chance in you-know-where of getting away with madoffesque mendacity. The broker-dealer/custodian I work with, for example, sends my clients monthly statements that are independent of any reports that I send to them. There is no way I could get away with producing rosied-up reports that showed investment accounts rising by 2% per month if at the same time clients are getting monthly reports from Pershing – the largest asset custodian on the planet, by the way – that tell a different story.
So the SEC’s proposed new rule in fact does nothing to improve the lot of the vast majority of investment advisor clients. The fact is that the SEC already has the power to do surprise audits of advisors who may have control relationships with broker-dealer and other investment entities that would make it easier for them to commit fraud.
The other issue that is in question here is the industry-wide practice of automatically deducting fees from client accounts. This wasn’t a problem for Madoff’s clients – he simply stole all their money and lied to them about it – but our newly hyper-sensitive regulators are now worried that this could become a problem. Here again, however, we have the proverbial tempest in a teapot. The fact that there have been virtually no reported abuses of this practice stems from the fact that there is, in truth, virtually no risk to consumers involved. First, all clients pre-approve such arrangements in writing. Second, advisors are already required by law to give clients notice of each transaction as it occurs. If there is a discrepancy between what a client expects to see and what occurs, it can and should be investigated. Third, independent broker-dealer/custodians again function as honest go-betweens in this regard. In short, the current system is open, straightforward, and efficient – and not in need of further regulation, which would only add complexity and cost to the system.
So why the proposed new rule? One can only conclude that it’s politics as usual.
