By: Matthew Arndt, CFA, CPA, CFP | May 19, 2009 | Illegal Schemes & Scams, Report Fraud, The Regulators, Who Can I Trust?

Currently, the SEC is proposing a rule that would require investment advisers to provide evidence to an independent accountant proving they actually possess their clients’ assets they say they have.  The rule aims to better protect the invested dollars of those who use investment advisers.

Regulators are concerned that it is too easy to cover up misappropriation of assets by sending clients phony investment statements regarding their accounts giving investors the false impression their money is in fact invested. This is typically what happens in ponzi schemes and investment frauds, including the Bernie Madoff scam.

The SEC is considering several proposals. One suggestion would be to subject advisers to an annual surprise exam by an independent accountant to verify the existence of client assets. A second proposal would require advisers annually show a federally regulated accounting firm they have the proper controls in place to safeguard client assets which would be in addition to the surprise examination.  

There is an early detection problem with both of these proposals. Namely there is a time-lag between when misappropriation of assets could begin and when the surprise exam or annual audit actually takes place. This is a serious risk for anyone considering investing a large amount of their net worth.

Instead, investors may want to consider the following to protect themselves: Make sure your adviser uses an independent custodian. Do not invest money with an investment adviser who performs both the investment and asset custody function. The line separating the custodian and adviser should not be blurred. The custodian of the assets should be completely independent of the investment adviser to reduce the potential for the kind of fraud we witnessed with the Madoff scandal. In other words, the investor should be making checks payable to or depositing money in a financial institution completely separate from the investment adviser’s firm.