Rob Dixon, Associate attorney at Davis Brown law firm
Rob Dixon, Associate attorney at Davis Brown law firm

The U.S. Securities and Exchange Commission (SEC) recently issued an unsettling warning: Out of hundreds of big investment advisory firms reviewed nationwide, about one-third – 140 firms – were not in compliance with rules designed to safeguard clients’ assets.

The compliance issues are serious because they could leave investors susceptible to potential fraud, say experts.

The SEC rule has prompted Iowa regulators to revise state rules that govern the 154 state-regulated investment advisory firms in Iowa. The federal rules cover 925 SEC-registered advisers in Iowa; those rules apply only to investment advisers managing at least $100 million in assets.

“It’s shocking, but I think it’s also easily remedied,” said Scott Eltjes, president and CEO of Des Moines-based BTC Capital Management, which manages approximately $2.5 billion in assets. His firm, an affiliate of Bankers Trust Co., has always used a separate custodian, a separate financial institution, for client assets. BTC also adheres to rules such as annual surprise audits, he said.

According to the SEC’s investor alert, the advisory firms were cited for various custody-related issues in the way they handle client assets. Advisers failed to recognize nuances that technically gave them control of their clients’ assets, or they mixed together client, proprietary and employee assets in a single account, or they fell short of surprise-exam requirements, the SEC found. In some instances, the firms, whose names were not released, were referred to the agency’s enforcement bureau for possible action, the SEC said.

The deficiencies relate to 2009 updates to the Investor Advisers Act of 1940 that require advisers deemed to have custody of client funds or securities to undergo annual surprise examinations by an independent accounting firm.

Investors should be aware of the SEC’s warning, but they should not become overly alarmed, said Rob Dixon, a securities attorney with the Davis Brown law firm in Des Moines.

“I would say unless a client is aware of some particular issues with his adviser, there’s no reason to panic here,” he said. On the topic of exactly who maintains custody of investment assets, advisers “should be very willing to have that conversation with you,” Dixon said.

“There are some cautionary tales here,” he said. “Even if an adviser does use a custodian, there are certain things that can deem the adviser to have custody.” For instance, if an adviser has been given account passwords by the client to go into his or her account to make trades, that can be deemed to be having custody of those assets.

“An adviser wants to avoid having custody if at all possible, because you’re opening yourself up to a whole new set of requirements,” Dixon said.

The Iowa Insurance Division, which regulates investment adviser firms that manage less than $100 million in assets, is in the process of updating its rules to conform with the federal custody rules. On March 29, the division filed a proposed rule that clarifies the definition of custody to follow the SEC definition, said Tom Alger, a division spokesman. The draft is based on a model rule devised by the North American Securities Administrators Association.

The proposed rule, which must still go through the full rule-making process. maintains an existing state requirement for advisers to be subject to an annual surprise examination of client funds, Alger said. However, it eliminates the option for an investment adviser to send account statements to clients in lieu of the custodian sending statements. If the adviser sends account statements to clients, a notice must be provided urging the client to compare the statements. Additionally, the current custody rule requires pooled investment vehicles that do not meet the audit requirement to provide an independent gatekeeper; the proposal requires the surprise exam plus a gatekeeper requirement.

Adviser custody issues have not yet been a problem in Iowa, Alger said. “With this (proposed rule), we’ll be in a better position to make sure it doesn’t become one,” he said.

BTC Capital, which earlier this year was recognized as one of the 50 fastest-growing advisory firms in the country, uses an outside custodian for every client account, Eltjes said.

“We give clients the option to use Bankers Trust as custodian, or they can use another third-party custodian,” he said. “I just personally think it’s a risk when an adviser acts as his own custodian.” The requirement to have a surprise audit conducted annually is an expensive proposition, he said. “There are compliance costs to the way we’re doing it, but to me it’s the only way to do it,” he said.

Eltjes said the surprisingly large number of firms out of compliance should bring extra scrutiny by regulators.

“From my standpoint, for the safety of our clients in the industry, this is something that we should want to fix and fix it quickly,” he said. “I think this is going to be a pretty strong initiative for the SEC. You just don’t want those kinds of black eyes on the industry.”