Advisors out in force against SEC's custody rule proposal

0628FP.SEC
Bloomberg News

Advisors and their representatives are lining up in opposition to an SEC proposal seeking to overhaul the ways they safeguard assets they've been entrusted by clients.

The Securities and Exchange Commission came forward in February with a proposed sweeping overhaul of its custody rule, which generally requires that advisors hold client assets at third-party banks, broker-dealers or trust companies for safekeeping. The main purpose of the rule is to extend custody requirements beyond assets like stocks and mutual funds to investment vehicles like cryptocurrencies, real estate and derivatives.

But it's another provision that financial planners were most concerned about in comments submitted to the SEC by a Monday deadline. The federal regulator's proposed rule would give advisors custodial responsibilities any time they had been granted authority to trade on clients' behalf.

Dennis Markway, the founder of Iron Horse Wealth Management in Johnston, Iowa, said most of his clients choose to allow his firm to conduct stock and other transactions without having to get permission for each individual trade. Such "discretionary trading" — as it's technically known — is popular because it prevents advisors from having to obtain investors' permission every time they want to carry out some piece of business.

"They are aware that they are relinquishing control to us," Markway said. "That's specifically what they're hiring us for."

In comments submitted to the SEC on May 8, Markway contended changes sought by the federal regulator would fall most heavily on small firms like his. Before an advisory firm could enlist an independent custodian to hold client assets, it would first have to have that third party enter into an elaborate written agreement.

Among other things, the pacts would pledge the custodian to provide records on investor assets on request. As a protection against bankruptcy, custodians would have to have investor assets set aside in funds that would be shielded from creditors.

RIA lawyers, a New York-based firm representing financial planners, noted in separate comments to the SEC that few advisors have direct relationships with custodians. Rather, custodians are often chosen directly by clients.

Max Schatzow, a founder and partner at RIA Lawyers, said, "It seems ridiculous to tell small advisors, or really any advisors, that they have to enter elaborate written agreements with these banks, broker-dealers and trust companies that they have no business relationship with and that their clients have independently selected."

"These qualified custodians have little to no incentive to enter into a written agreement with the smaller investment adviser," RIA Lawyers wrote in its comments to the SEC. "In fact, these qualified custodians often have investment advisers, banks, or trust companies that compete with these smaller investment advisers. 

The Investment Company Institute, which represents mutual funds and similar investment vehicles, noted in comments to the SEC that the custody rule now applies to investment advisors only in very limited circumstances. The SEC has long said the advisors fall under the current custody rule only when they have power of attorney to sign checks on clients' behalf or withdraw money or securities from their accounts. Authorized trading was explicitly excluded.

"The Proposal would equate an adviser's discretionary trading authority over assets with having custody of those assets for the first time," the Investment Company Institute wrote. "We oppose these changes because doing so is unnecessary and yet will create a significant number of practical difficulties."

SEC figures support the notion that most clients give advisors discretionary authority to trade on their behalf. The regulator's proposed rule notes that of $128.96 trillion in assets that advisors were managing by June 2022, $117.57 trillion was in discretionary accounts.

SEC officials have said their proposed changes to the custody rules come in response to recent technological changes and other trends related to investing. SEC Chairman Gary Gensler has said he wants to make sure that clients who turn to advisors for help putting money into alternatives like digital assets, private securities, real estate and derivatives are getting the same protections as investors who stick with standard stocks and funds. 

The custody rule, added to the Investment Advisers Act in 1962, has not been revised since 2009, when amendments were approved in response to frauds like the $65 billion Ponzi scheme perpetrated by Bernie Madoff, a registered advisor who exercised direct control over his clients' assets. 

The Investment Adviser Association, another opponent of many of the proposed changes to the custody rule, agreed in comments to the SEC that investor protection should be the regulator's priority. But the group representing independent advisors also sided with critics who said the SEC's proposal would go too far in many ways.

"Many requirements of the proposed rule would compel the adviser to police commercial terms between clients and custodians on matters unrelated to the investment advice provided by the adviser," the IAA wrote.

Another point of contention for the IAA: The length of time the SEC would give firms to come in compliance. If the federal regulator gives the rule final approval, advisors with $1 billion or less of assets under management would have 18 months for compliance. Firms with more AUM would have only a year. The SEC estimates that 10,454 advisors, or nearly 70% of all registered advisers in the U.S., would come under the 18-month deadline.

IAA officials wrote that they appreciate the additional time that would be granted small firms.

But, the IAA wrote, "given the scope of work that will be necessary for advisers (and custodians) to implement the Proposal, as described throughout this letter, however, the proposed implementation periods are too short."

For reprint and licensing requests for this article, click here.
Regulation and compliance Capital markets Equities Independent advisors Investment funds Investments Regulatory reform RIAs Cryptocurrency
MORE FROM FINANCIAL PLANNING