Schapiro, who served as CEO of Financial Industry Regulatory Authority, the self-regulatory organization for broker/dealers, was appointed by President Barack Obama on January 20 and was confirmed unanimously by the Senate and sworn in as SEC chairman on January 27, becoming the first woman to serve in the post.



With her strong ties to FINRA, many RIAs have speculated that Schapiro would act to bring regulation of RIAs into alignment with brokers, a development most RIAs do not welcome and most B/Ds cheer. RIAs managing more than $25 million are regulated by the SEC while those with less than $25 million under management are regulated by state securities bureaus. Brokers are licensed by FINRA and supervised by broker/dealers.



Compliance regimes imposed by most B/Ds on registered reps are generally far more invasive and bureaucratic than the compliance system faced by RIAs. However, B/Ds have a long history of violating rules governing sales to retail investors, while instances of abuses by RIAs been comparatively rare.



The $65 billion Ponzi scheme by Bernard Madoff has created an environment in which investors and legislators are demanding change to the regulatory framework, which is widely considered to have been outmoded in recent years by the growing use of complex derivatives, unregistered hedge funds, and private equity partnerships, and the conflicts of interests at credit rating agencies responsible for passing judgment on debt issues that pay huge fees to the rating giants. In her prepared remarks, Schapiro’s promised to address a number of these issues.



While Schapiro offered no details about how she might bring BD and RIA regulation into closer alignment, her remarks make it clear that a review of the regulatory framework faced by RIAs is high on her list of priorities for 2009. An area affecting RIAs that she offered some details about are instances in which an RIA takes custody of assets. While few RIAs accept custody of client assets, the Madoff fraud would likely have been discovered sooner if stricter rules had been in effect governing instances in which RIAs take custody of client assets.



“I have asked the staff to prepare a proposal for Commission consideration that would require investment advisers with custody of client assets to undergo an annual third-party audit, on an unannounced basis, to confirm the safekeeping of those assets,” Schapiro said. “I also expect the staff to recommend proposing a rule that would require certain advisers to have third-party compliance audits to review their compliance with the law. And to ensure that all broker-dealers and investment advisers with custody of investor funds carefully review controls for the safekeeping of those assets, I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets.”



Schapiro said the list of certifying firms would be publicly available on the SEC's website so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors.

Five more advisory firm frauds made headlines in the past week. Meanwhile I received two hateful emails about my recent blog posts saying old ways of assuring clients of advisor integrity are no longer enough.



I’m sorry if I stepped on some toes or if you feel I was too harsh with my comments about NAPFA. But unless advisors communicate proactively, candidly, and in detail with clients right now about the trust issue, client assets could start moving away from advisors toward discount brokers.



I’m not predicting a huge stampede. But clients who have seen portfolios slashed in value and who see the string of frauds make headlines need reassurance.



During the last market pullback—the tech bubble of 2001-2002—discount brokers did not have the easy-to-use technology they do today, and only a fraction of the investors used the Internet. It’s different this time. Advisor clients are on the Web and the discount brokers have slick, easy-to-use interfaces.



The history of innovation should make advisors cautious. Disruptive technology systems (discount brokers) are always viewed as crude when introduced. This lulls established market leaders relying on existing technology (traditional financial advice outlets) to believe they will not lose business to the new competitor.



However, incremental improvements in once-crude innovative systems gradually overcome the established regime. This pattern of innovation adoption has been documented extensively.



Advisors would be wise to watch the progress of the major discount brokers in coming months to see how much market share they pick up from the retail flight of assets from Wall Street brokers.



Ironically, advisors are more than ever in need of help from the big discount brokers. After all, these same firms are also the largest providers of custody services to RIA assets. And the custodians can provide advisors with crucial assistance in reassuring their clients of their fidelity and competence.



Perhaps the most important idea an RIA can communicate to assure clients fearful of fraud is that you have an independent custodian. This is a time to emphasize to clients that, unlike Bernard Madoff, you have an independent custodian.



Because of the important role an independent custodian plays in RIA client relationships, I emailed four major custodians a week ago—Fidelity, Pershing, Schwab, and TD Ameritrade. I asked them how RIAs can reassure their clients by emphasizing the role played by a custodian. Only two of the custodians responded.



To me this was surprising. Here’s a chance for the custodians to be on your side and play a valuable role. Your custodial firm can earn its fees by helping you communicate proactively right now. You’d think they would jump at that chance.



Mark Tibergien, who heads Pershing Advisor Solutions, replied within minutes. Brian Stimpfl, a managing director at TD Ameritrade Institutional, responded a day later by spending an hour on the phone with me.



If Fidelity and Schwab contact me after seeing this post and have good ideas to add, I’ll post another entry. Keep in mind, Advisor Products is incorporating these messages into articles we write for RIA client newsletters and websites.



Tibergien says the simple fact that you have a custodian must be communicated to clients. Madoff’s firm was itself custodian of client assets. Almost all custodians mail statements monthly directly to clients. You want to mention to your clients that these statements provide independent verification of their account holdings, transactions, and values.



Stimpfl points out that only about 1,000 of the approximately 11,000 RIAs providing retail investment advice take custody of client assets. You may want to mention to clients that RIAs not holding their assets at custodians require far more due diligence on an ongoing basis.



Clients should understand that portfolio performance reports they get from an RIA can easily be compared against the independent custodian’s statement. This is also a good time to remind clients that custodians will send them notices of trade confirmations whenever a transaction occurs in their accounts. Mentioning that the custodian has its own website where account values are posted 24/7 would also reassure many clients.



You may also want to remind clients of the URL on the custodian’s website where they can sign up to receive the electronic trade confirmations directly from the custodian. Custodians years ago rolled out a feature allowing them to notify your clients of trade confirmations and they can send an email to your clients with the URL where they can download each trade confirmation. They also archive every confirmation for each client. Many clients will appreciate the reminder and your being proactive in disclosing how transparent your business is. It will instill confidence in your firm.



Incidentally, you may want to ask your custodian about its policy on ex-clients. If you move a client’s assets away or if the client fires you and moves to another clearing firm, how long will the custodian keep those old trade confirmations? Stimpfl says they’re archived for seven years at TD Ameritrade.



Stimpfl says several months ago TD Ameritrade produced and distributed a set of materials for RIAs to help them answer questions from nervous investors after the Madoff scandal and market break. The package of materials included a letter that could be copied, pasted, personalized, and mailed out under the RIA’s letterhead.



The letter, Stimpfl says, reminded clients to check their client services agreement with their RIA firm to see exactly what their advisory firm can do with their money. Reminding clients that you have discretion to trade their accounts and how carefully you manage that responsibility would be reassuring. While the majority of RIAs do have discretion of their client accounts, those that do not may want to remind their clients of this fact.



“We live in a transparent society,” says Stimpfl. “And if you're holding back anything, you could unintentionally and unnecessarily put client relationships at risk.”



RIAs who invest in alternative investments should be proactive in communicating about the value of those assets. Advisors who recommend alternative investments should have Investment Policy Statements for each client who holds them. Reminding these clients of the details about holding alternative investments would be wise. Advisors who do not hold alternatives or who hold less than 5% of total client assets in them should consider reminding clients of these facts.



Tibergien says clients should be told about processes and protocols your firm has in place to review investment decisions. If your firm has conducted a “mock SEC audit,” showing clients a report from your compliance consulting firm would be another way to demonstrate your commitment to run your firm with integrity.



You can also remind clients that your custodian has its own responsibilities under the law to ensure client assets are protected. SIPC insurance covers investors in the event of the insolvency of the custodian for up to $500,000 of losses. In addition, a custodian is likely to have separate insurance coverage purchased privately. One custodian has coverage for losses in securities accounts of up $149.5 million and up to $900,000 in cash accounts.



And speaking of cash accounts, Stimpfl says TD Ameritrade has safeguards in place that prevent an RIA from moving cash from a client’s account into the firm account. RIAs can move cash from a client’s account to another account held by the same client, but TD Ameritrade must receive written approval via mail. Similarly, client address changes must be verified via mail.



Finally, both Pershing and TD Ameritrade said they have automated systems in place to monitor RIA client accounts. Software to ensure compliance with anti-money laundering laws and programmatically search for suspicious trading patterns in customer accounts are yet another protection for RIA clients.



By the way, the two hateful emails I received were more than offset by two uplifting messages. I appreciate the kindness and support.





One More Thing:

If you are interested receiving notification of the continuing drumbeat of advisor frauds being uncovered almost daily, I’ve been “tweeting” the headlines about them. Follow me on Twitter to receive these notifications. Here’s the recent crop of those tweets: